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Articles & Commentary

Just to be perfectly clear about this:  You are reading an article posted on a lawyer’s webpage, commonly called a “blog”.  Blogs are not legal advice.  You should not rely on a blog as your lawyer.  You’re not my client, and I’m not your attorney (unless we already agreed to that in writing).  I’m telling the truth as I see it, but unless you have a particular problem and you want to tell me all the facts about it (and sign an engagement letter), and I get to do specific legal research about your facts, I’m not offering you a free legal opinion here.  As long as you’re okay with this, please read on!

COMMENT ON A MARCH 2020 FINRA ACTION REGARDING A RULE G-23 VIOLATION

--Pamela W. Peterson, August 28, 2020, copyright 2020

In the implementation of rules and regulations governing municipal advisor activity, there was some concern about whether the MSRB’s Rule G-23 would continue to be relevant.  In contrast to the MA rules, which created an entirely new class of regulated persons and entities, Rule G-23 applied only to entities who were clearly under the aegis of the MSRB from a regulatory standpoint: municipal broker-dealers.

A March 2020 FINRA case answers that question.  An underwriting firm was disciplined for acting as both a Rule G-23 “financial advisor” and an underwriter for the same client and, more important, for the same issuance.

Before moving into the details of this case, a word about the term “financial advisor”.  Before recent changes in the laws, almost anybody could call themselves a ‘financial advisor” and the term was used, indiscriminately, for ordinary brokers who did not have a fiduciary relationship to their clients, for independent advisors who were not associated persons of a regulated entity, and sometimes for the employees of registered investment advisors.  It also had a special, defined, meaning in the context of Rule G-23: the rule defines a “financial advisory relationship” as one in which a "municipal securities dealer renders or enters into an agreement to render financial advisory or consultant services to or on behalf of an issuer with respect to a new issue or issues of municipal securities…”  (Emphasis added.) As with the Municipal Advisor rules (which cover this, plus a broader range of services), it’s the action of rendering advisory services (or agreeing to render advisory services) that defines the actor.

The broker in the FINRA action had a blanket advisory agreement with an issuer for a period of seventeen months.  Blanket agreements like this had been addressed by the MSRB in a letter dated January 5, 1981, in which the MSRB stated: “…..where a dealer has entered into a blanket agreement to render financial advisory services, a financial advisory relationship with respect to a particular issue of securities may be presumed to exist despite the fact that the municipal securities dealer does not furnish any financial advice concerning such issue.”  (Emphasis added.)  It is possible that the broker read the following sentence in that 1981 letter as permitting “wiggle room” (if the broker could present information that would show that it had NOT advised on a particular issue, the MSRB might have okayed that.  I don’t think that’s a sound interpretation; it’s always hard to prove a negative, and there’s no explicit statement that would allow such wiggle room.)  The broker had agreed to waive its FA fee for three separate issues on which it acted as underwriter, and had only done so after agreement in writing by the issuer for the role switch.  The broker thought that cured the problem.

But there’s more to this problem than just the fees for acting on one side or the other of the transaction.  Once a firm takes on the role of financial advisor it is acting as an agent, and at least as far as the problems of raising capital are concerned, the agent’s duty is to ask this question: what’s best for the client?  Is it a true bank loan?  A new municipal bond issuance?  A private/public partnership?  A change in the tax or fee structure?  A sale of municipal assets?  Given that a brokerage firm may benefit very differently from those choices (including: not at all, except for an advisory fee), it’s a clear conflict of interest to participate in a new issue, even if the firm can prove that it didn’t in any way, shape, or form, recommend the issuance.  It’s hard to imagine how a firm could do that, other than by providing proof that it recommended something else and the issuer overrode that recommendation.  (In which case, what does that say about the firm’s effectiveness as an advisor?) 

The clear thrust of regulatory oversight in this area for at least the last ten years has been: you can’t be on both sides of the table.  Advising the issuer is a fiduciary role, and fiduciaries cannot opt out of that role to their own benefit, regardless of whether such benefit is objectively reasonably priced and regardless of whether the principal doesn’t mind.  Ever since Rule G-23 was amended to prevent such role-switching (well before the MA rules were enacted), that’s been the clear message of the regulators. 

The trickiest part of all this for a firm seeking a role is the opening of a relationship with an issuer.  I’ve noted that it might be simpler if dual advisor/underwriter firms threw a rock through the window before the initial meeting started, wrapped in a paper that said “We want to be your (check one) ___underwriter   ___municipal/financial advisor.”  (Okay, just kidding, but barely.) 

Larger, more sophisticated issuers may well feel deprived of freedom of choice here; they would prefer to interview a range of firms with varying attributes (terrific experience/good at explaining things to finance committees/great retail and institutional distribution/experts on a bond sector) and then assign the players to appropriate roles.  Also, smart issuers have long looked for “loss leaders” in the form of “sample advice” in RFPs or informal presentations, too.  (In house counsel has heard the complaint often: “Issuer took OUR idea and gave the deal to Those Other Guys!  Is that legal?”) 

It’s worth noting that the background of regulation often focuses on protecting the unsophisticated, including unsophisticated issuers.  Smaller towns, rural counties:  they have capital needs, but they often do not have financial expertise.  Because of this, it’s easy for them to be taken advantage of by smart, but unscrupulous persons.  The kind of persons we’re all happy to see barred from the securities industry for life.  The relatively small fine paid by the broker-dealer in the instant case suggests that FINRA saw them as having misinterpreted a rule rather than being actual Bad Guys.  However, the writing’s on the wall after this case. 

Takeaways:

1)  Rule G-23 still matters.

2)  Pick a side of the table as early as required by the regulations and stick to it.

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ROCK

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HARD PLACE

DAMNED IF YOU DO, DAMNED IF YOU DON’T: 

THE TRICKY WORLD OF ADVERTISING MUNICIPAL SECURITIES 

by Pamela W. Peterson       4/1/2019    Copyright 2019

The MSRB will be implementing new guidance concerning advertising for both municipal securities dealers and municipal advisors on August 23, 2019.  The guidance reiterates existing standards for truthful advertising, but expands considerably on what that means in an age when the Internet and social media are the go-to sources for information, rather than print (or occasionally, broadcast media).

For a start, it’s worthwhile to observe that securities law generally disfavors everything that business school graduates are taught about advertising and marketing.  Ad agencies, publicity agents, marketing consultants and the like are astounded daily to learn that there are fields where slogans like “Sell the sizzle, not the steak” point straight to felonious conduct charges.  (We are not alone: the FDA has extremely strict rules about what drug manufacturers can claim about their products, for instance.)  As dealers and municipal advisors interface with their issuer clients or counterparties, they will find that states, counties, cities, towns, and villages often have Directors of Communications who are understandably unsophisticated about this topic.  Those folks (and they’re kind, dedicated people, generally speaking) may be downright disbelieving when someone points out that they must not market new issues of municipal securities the same way that they market the local jazz festival, business development areas, and a nice local selection of bed-and-breakfast lodgings.

But the simple fact is that Rule 10b-5 applies to everybody, to “any person” who defrauds another person in “the purchase and sale of any security”.  (Rule 10b-1 makes it clear that it applies to securities that are exempt from registration, such as municipal securities.)  When I had the task of instructing incoming analysts at several large investment banks, I used to characterize it this way:  “If your grandmother sells your grandfather ten shares of Microsoft in their living room, Rule 10b-5 applies.”  And it certainly applies to the Director of Communications who uses a local government webpage to ballyhoo an upcoming security offering to potential purchasers, without any cautionary language whatsoever. 

So what is tricky about the MSRB guidance?  Well....at the same time that the MSRB is sternly saying that a dealer or municipal advisor who merely links to an issuer’s webpage can be found to have “adopted” the language on that webpage, it is also saying that when the dealer or advisor has any kind of say-so about the content on third-party websites, it may have, because of that “entanglement”, also adopted the resulting language.  The issuer's personnel don't work for, or report to, the dealer or municipal advisor, of course.  There's no supervisory relationship, no day-to-day control.  But: what does it mean if one conferred with the issuer about statements on its website?

This all seems to leave the dealer or advisor between a very dense rock and an extremely hard place.  It is increasingly common to include links to information that is external to the hard-copy versions of a printed preliminary or final official statement.  There are good reasons for this:  the most current information on property tax collection, the most recent information on economic activity in a jurisdiction may well be found on a routinely updated external website.  That’s valuable information for a bond purchaser.  Yet the dealer or advisor does not—and if the warnings in the MSRB guidance are to be taken seriously, probably should not—control the content of such websites.  So--if you're not in control, ask yourself what else could be added by an over-zealous marketing official without your keen understanding of full disclosure obligations?  (You should have gotten a chill of foreboding at this last sentence.)
 

There are a number of things that dealers and municipal advisors could do to protect themselves in this Era of the Google.  What follows is not legal advice (see disclaimer above), but points that readers may wish to discuss with their own counsel. 

  1.  Contracts with an issuer may need to address this point: if any issuer websites are to be linked to the dealer or advisor websites, all issuer personnel who post on them about new security issues and offerings must have the such text reviewed and pre-approved by experienced securities counsel.

  2. A dealer or advisor may wish to create a standard set of communications explaining why securities advertising cannot be like new car advertising, but must comply with securities laws.  It will help to create such materials in plain English with good examples of what’s wrong and what’s okay, and with an emphasis on the ethics and laws that require the selling of securities with full and fair disclosure.

  3. Contracts with an issuer may need an “out” clause if the issuer begins to post unsuitable materials on its linked-to websites and refuses to correct the web pages or the behavior.

  4. Disclosure documents may need to include explicit language that makes it clear that, just as the document itself speaks as of its date, and will not be updated beyond a close-in-time-to-the-offering period, any websites linked to in it are also subject to the same conditions.
     

In sum, we all need to use the Internet responsibly.  As a tool for disclosure, it’s a marvel.  But like any means of communication, we need to ensure that the principles of fair dealing, full disclosure, and compliance with the securities laws apply here, just as they do in printed materials and in verbal discussions with potential purchasers.  Municipal securities continue to be a favored investment for many retail investors.  They merit this kind of careful compliance; the object is to sell suitable securities to informed buyers.  Godspeed.

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