MSRB Announces New Protections for State and Local Governments that Issue Bonds

FINRA Arbitration and Litigation Attorney Russell L. Forkey, Esq.

May, 2012:

MSRB ESTABLISHES NEW PROTECTIONS FOR STATE AND LOCAL GOVERNMENTS THAT ISSUE BONDS

The Municipal Securities Rulemaking Board (MSRB) recently announced that, beginning in August, underwriters of municipal securities will be required to disclose to their state and local government clients risks about complex financial transactions, potential conflicts of interest, and compensation received from third-party providers of derivatives and investments, among other new requirements. The new rules include explicit and expanded requirements for underwriters aimed at protecting state and local governments that issue municipal bonds.

“These new rules are the biggest development in protection of the financial interests of state and local governments since the MSRB was established in 1975,” said MSRB Chair Alan Polsky. “We have acted decisively and consistent with our mandate to protect state and local governments established by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The new requirements, which have the force of federal law, will ensure that state and local governments have important information they need to make informed decisions about issuing bonds and related transactions.”

MSRB rules already prohibit an underwriter from engaging in any deceptive, dishonest or unfair practice with respect to an issuer of municipal securities. However, a key theme of the new rules is ensuring that state and local governments have important information to make the best decisions when undertaking financial transactions. A municipal bond issuer should be informed about the material risks of an interest rate swap recommended by its underwriter. It should also know whether its underwriter is issuing or purchasing credit default swaps in its securities since those swaps could affect the pricing of the issuer’s securities.

Under current law, all representations that underwriters make to state and local governments must be truthful and accurate. The new rules provide specific examples of how underwriters must fulfill this obligation. For example, an underwriter may not represent that it has the requisite knowledge or expertise with respect to a particular financing if the personnel that will work on the financing do not have that expertise. The new rules also prohibit excessive compensation of underwriters, determined by the specific facts and circumstances of the offering, and require that the price paid by an underwriter for an issuer’s bonds must be fair and reasonable.

The principles covered in the new regulations are summarized below. Read the complete new regulations.

• An underwriter is required to provide robust disclosures as to its role, its compensation and any actual or potential material conflicts of interest.
• All representations made by underwriters to state and local governments must be truthful and accurate and may not misrepresent or omit material facts.
• Underwriters of municipal bond issues that recommend complex municipal securities transactions or products are required to disclose all material financial risks and characteristics, incentives and conflicts of interest regarding the transactions or products.
• An underwriter’s duty to have a reasonable basis for the representations it makes to a state or local government extends to representations made in connection with the preparation by the state or local government of its disclosure documents.
• The duty to treat state and local governments fairly includes an implied representation that the price an underwriter pays to a state or local government is fair and reasonable, taking into consideration all relevant factors.
• Underwriters are required to disclose potential conflicts of interest, including the existence of third-party payments, values, or credits made or received, profit-sharing arrangements with investors, and the issuance or purchase of credit default swaps for which the underlying reference is the state or local government whose securities are being underwritten.
• Underwriters are reminded not to disregard the state and local governments’ rules for retail order periods by accepting or placing orders that do not satisfy the state and local governments’ definitions of “retail.”