Municipal Securities Rule Making Board (MSRB) NOTICE 2011-67

Municipal Securities Fraud, Misrepresentation and Suitability FINRA Arbitration and Litigation Attorney, Russell L. Forkey, Esq.

November, 2011:

MSRB ANSWERS FREQUENTLY ASKED QUESTIONS REGARDING DEALER DISCLOSURE OBLIGATIONS UNDER RULE G-17

The following post is a must read for investors dealing in municipal securities.  It provides general information about such matters as what disclosures a dealer must provide a customer and when must a dealer disclose material information to a customer, even if the dealer is not recommending the investment.

Please keep in mind that this information is being provided for education purposes only.  Consequently, it is not designed to be complete in all material respects.  Thus, it should not be relied upon a providing legal or investment advice.  If you have any questions relative to the following, you should consult with a qualified professional.

BACKGROUND:

On September 20, 2010, the MSRB and FINRA issued reminder notices to brokers, dealers and municipal securities dealers ("dealers") of their sales practice obligations when selling municipal securities in the secondary market (the "2010 Notices"). The 2010 Notices reiterate MSRB interpretive guidance issued to dealers in prior years, including MSRB Notices 2002-10 (the "2002 Notice") and 2009-42 (the "2009 Notice"), which were filed with the Securities and Exchange Commission ("SEC").

Since the issuance of the 2010 Notices, dealers have raised questions regarding the Notices and their obligations to customers in secondary market transactions of municipal securities. Consequently, the MSRB prepared the following answers to the most frequently asked questions about those obligations, which apply equally to primary market transactions with customers.

What is the basis for a dealer's fair dealing obligation under MSRB Rules?

MSRB Rule G-17 sets forth the basic customer protection obligation of dealers when executing municipal securities transactions with or on behalf of customers. It provides that, in the conduct of its municipal securities activities, each dealer shall deal fairly with all persons and shall not engage in any deceptive, dishonest, or unfair practice. The rule contains an anti-fraud provision, and a general duty to deal fairly, even in the absence of fraud.

What disclosures must a dealer provide to customers?

A dealer must disclose, at or prior to the sale of municipal securities to a customer, all material information about the transaction known by the dealer, as well as material information about the security that is reasonably accessible to the market.  Information available from "established industry sources" is deemed to be reasonably accessible to the market.  In the case of Sophisticated Municipal Market Professionals ("SMMPs"), the disclosure obligation may be deemed satisfied if a dealer complies with certain requirements established by the MSRB in prior guidance.

When must a dealer disclose material information to a customer?

A dealer must disclose material information about the security or transaction at or prior to the time of sale to a customer.  This obligation includes a duty to give the customer a complete description of the security, including a description of the features that likely would be considered significant by a reasonable investor and facts that are material to assessing the potential risks of the investment.

What is an "established industry source?"

The MSRB has defined an established industry source as a source of information relating to municipal securities transactions generally used by dealers that effect transactions in the type of municipal securities at issue.  The MSRB has previously indicated that sources such as rating agency reports and the MSRB's Electronic Municipal Market Access ("EMMA") system are considered to be "established industry sources." These sources are not the only "established industry sources." Rather, the MSRB has noted that information vendors and other organizations may provide industry professionals with access to information that is generally used by dealers to effect transactions in municipal securities.  The MSRB expects that, as technology evolves and municipal securities information becomes more readily available, new "established industry sources" are likely to emerge. Moreover, the sources of information used by dealers that effect transactions in municipal securities may vary with the type of municipal security.  For this reason, the MSRB has indicated that a dealer might draw on fewer industry sources to disclose all material information about a "triple-A" rated general obligation bond than for a non-rated conduit issue.  Conversely, to the extent that a security is more complex, for example because of complex structure or where credit quality is changing rapidly, a dealer might need to take into account a broader range of information sources prior to executing a transaction.  Each dealer must determine the range of information sources it will use to obtain material information regarding a particular municipal security.

What is material information?

In general, information is considered "material" if there is a substantial likelihood that the information would be considered important or significant by a reasonable investor in making an investment decision.  The scope of material information that dealers are obligated to disclose to their customers is not limited solely to information made available through established industry sources. Dealers also must disclose material information they know about the securities even if such information is not then available from established industry sources.

Must a dealer disclose material information to the customer even if the dealer is not recommending the municipal security to the customer?

Yes. Even where the customer is placing an "unsolicited order" and the dealer is acting as a "mere order-taker," the dealer has the same fair dealing obligation to disclose all material information to the customer regarding the security and the transaction.

Must a dealer use search engines and other internet tools to locate all material information regarding the municipal security at issue?

While dealers may chose to use search engines and other internet tools in their material information inquiries, they are not obligated to do so. As the MSRB stated in 2002, the level of inquiry performed by a dealer may vary based on the nature of the security.  A dealer might, for example, choose to conduct a search using an internet search engine or to use other tools when the issue is unrated or unfamiliar to the dealer. The MSRB does not mandate a particular level of inquiry by dealers. Rather, each dealer must determine the scope of its own inquiry as may be necessary to meet its obligations as a marketplace professional. As the MSRB stated in the 2009 Notice, "as professionals in the marketplace, dealers use a combination of internal resources and public and proprietary information sources to obtain the information necessary to conduct their business in a professional manner and to meet their disclosure and fair practice duties to investors."

Do dealers who sell municipal securities to customers using electronic platforms have the same fair dealing and disclosure obligations as other dealers?

Yes. Dealers are subject to the fair dealing and disclosure obligations under MSRB Rule G-17, regardless of the manner in which the customer purchases the municipal security. Dealers operating electronic trading or brokerage systems have the same obligations to disclose material information as other dealers.  The MSRB has noted that the provision of electronic access to material information to customers who elect to transact in municipal securities on an electronic platform is generally consistent with a dealer's obligation to disclose such information, but whether such access is effective disclosure for purposes of meeting the disclosure obligation under MSRB Rule G-17 ultimately depends upon the particular facts and circumstances present.

What are the supervisory obligations of dealers regarding the fair dealing and disclosure obligations under MSRB Rule G-17?

Under MSRB Rule G-27, dealers must supervise their municipal securities business and ensure they have adequate policies and procedures in place to monitor the effectiveness of their supervisory systems.  They must supervise the municipal securities activities of their associated persons, have adequate written supervisory procedures, and implement supervisory controls to ensure their supervisory procedures are adequate.  Importantly, dealers must implement processes to ensure that material information regarding municipal securities is disseminated to their registered representatives who are engaged in sales to and from customers. It would be insufficient for a dealer to possess such material information, if there were no means by which a registered representative could access it and provide such information to customers.