A new rule will take effect on July 1, 2014 that regulates persons and firms that provide advice to municipal issuers and obligated parties regarding municipal financial products or the issuance of municipal securities. Although the Municipal Advisor Rule (the Rule) was originally scheduled to take effect on January 13, 2014, the U.S. Securities and Exchange Commission (SEC) has postponed the effective date to allow the participants in the municipal securities marketplace more time to analyze, implement and comply with the Rule. In the meantime, the SEC staff has issued unofficial guidance in the form of frequently asked questions (FAQ). In addition, on January 9, 2014, the Municipal Securities Rulemaking Board (MSRB) issued for comment a draft regulatory notice regarding the Rule. Additional guidance will be issued by the MSRB, and likely the SEC as well, over the coming months.
The Rule will carry out a requirement of the Dodd-Frank Act, which provides that it is illegal for a municipal advisor to provide advice regarding municipal financial products or the issuance of municipal securities unless the Municipal Advisor is registered with the SEC. Prior to enactment of the Dodd-Frank Act, the only financial advisors subject to federal regulatory requirements were broker-dealers and banks. The Rule exempts certain persons from being considered a Municipal Advisor with respect to a specific transaction.
The Rule will change how information flows in the municipal securities market. The only persons who will legally be permitted to provide certain kinds of advice will be Municipal Advisors and those who fall within an exception.
A threshold issue for market participants is determining whether they meet the definition of a “Municipal Advisor” and, if excepted, what the limits of the applicable exception are. For municipal securities issuers and obligated persons (that is, generally, conduit borrowers such as tax-exempt health care institutions, developers of low income housing or providers of certain tax-advantaged facilities), the Rule may significantly restrict the flow of information from other market participants, such as underwriters. This Client Alert will touch briefly on who is treated as a Municipal Advisor, the standards applicable to Municipal Advisors, how the Rule may affect municipal securities issuers and obligated persons (collectively referred to as “Borrowers”) as well as other market participants, and it will conclude with some suggestions as to how Borrowers and other market participants may promote the flow of information.
Who Is a Municipal Advisor?
The Rule defines a “Municipal Advisor” as a person that, unless excluded or exempted under the Rule, provides advice to or on behalf of a municipal entity or obligated person with respect to municipal financial products or the issuance of municipal securities, or undertakes a solicitation of a municipal entity or an obligated person. Unless exempted, a Municipal Advisor must register with the SEC, owes certain duties to its clients, and cannot act in ways that are adverse to its clients. Thus, for example, a firm that is a Municipal Advisor to a Borrower may not serve as an underwriter for securities issued by that Borrower with respect to which the firm provided municipal advice. An unregistered person or firm that provides municipal advisory services and does not qualify for an exemption is violating federal securities laws and subject to sanctions by the SEC.
Unpacking the Definition
To understand the Rule and its potential impact, it is helpful to review the key terms, which are highlighted above.
Advice. According to the SEC, “advice” does not have bright-line definition. However, information of a general nature that does not involve a recommendation will not be considered to be “advice”, whereas information that involves a recommendation, or that invites a Borrower to act or refrain from acting, with respect to an issuance of municipal securities or investment of the proceeds of such securities will likely be considered to be advice. The more the information addresses the specific needs, objectives, or circumstances of a Borrower with respect to municipal financial products or the issuance of municipal securities, the more likely the SEC would find that such information is “advice”. Note that the SEC has stated that it does not believe that a person must receive compensation from a Borrower for providing advice in order to be considered a Municipal Advisor.
The FAQ provides further guidance. Information that is particularized to a Borrower could fall within the general information exclusion if it is “factual in nature and does not contain or express subjective assumptions, opinions or views, or constitute a recommendation.” Further, disclosure and disclaimers bear upon whether or not a person’s communications with a Borrower would be a recommendation. Similarly, business promotional materials are not “advice” if such materials are factual. Examples given include a “hypothetical new issue pricing range that takes into consideration current market conditions and certain factual information particularized to an issuer … and mathematical calculations of an issuer’s hypothetical potential interest cost savings if it were to issue refunding bonds … at a range of estimated current market rates.” However, the “more individually tailored” to a specific Borrower, the more likely the information will be considered to be a recommendation.
Borrower - Obligated Person. A “municipal entity” is, essentially, a state or local governmental entity with the power to issue municipal securities. An “obligated person” generally refers to a party that is ultimately obligated to pay debt service on municipal securities, other than certain credit enhancers, such as bond insurers or letter of credit providers (essentially tracking Rule 15c2-12).
Issuance of Municipal Securities. The SEC construes broadly both the activities and the timing related to the issuance of municipal securities. The activities relating to the issuance of municipal securities include the structure, timing, terms and other similar matters of such securities. The SEC has also stated that the restrictions of the Rule apply throughout the life of an issuance of municipal securities, from the pre-issuance planning stage to the repayment stage.
Municipal Financial Products. According to the FAQ, “municipal financial products” relate only to the investment of the proceeds of municipal securities. Thus, a person advising a municipal entity or an obligated person regarding investment or other similar uses of funds needs to know the source of the funds. If they are proceeds of municipal securities, the advisor must be registered or exempted.
Solicitation. The definition of “solicitation” is straight forward. Anyone engaged by a third party to recommend that party to municipal issuers or obligated persons is soliciting and is, accordingly, a Municipal Advisor subject to the Rule.
Exceptions and Exemptions From the Definition of Municipal Advisor
The Rule contains a number of exceptions and exemptions. The exceptions generally relate to the role of the specific party and are narrowly drawn to reflect the SEC’s view of the function of such parties in a transaction. The exemptions, in contrast, are primarily related to the Borrower’s specific situation, such as being represented by a Municipal Advisor or undertaking an RFP process. Set forth below is a brief summary of the exceptions and exemptions from the Rule’s prohibition on giving advice.
Public Officials and Employees. In a change from the preliminary draft of the Rule issued by the SEC, members of a governing body of a Borrower or employees of a Borrower acting within the scope of their official duties or employment.
Underwriters. A broker, dealer, or municipal securities dealer serving as an underwriter of a particular issuance of municipal securities to the extent that such person engages in activities that are within the scope of an underwriting.
Registered Investment Advisors. Any investment advisor registered under the Investment Advisors Act of 1940 to the extent that such person is providing investment advice in such capacity. Such advice does not, however, include advice regarding the issuance of municipal securities.
Attorneys. Any attorney to the extent that the attorney is offering legal advice or providing services that are of a traditional legal nature.
Engineers. Any engineer to the extent that the engineer is providing engineering advice.
Accountants. Any accountant to the extent that the accountant is providing audit or attest services, preparing financial statements or issuing letters for underwriters for, or on behalf of, a Borrower.
Banks. Banks, to the extent that the bank provides advice with respect to (a) investments held in accounts with the bank, (b) extensions of credit by the bank to a Borrower (including issuing letters of credit or direct purchases of municipal securities by the bank), (c) funds held in a sweep account, or (d) investments made by the bank in its capacity as trustee.
Swap Dealers. Swap dealers registered under the Commodity Exchange Act that recommend a municipal derivative or a trading strategy that involves a municipal derivative so long as such swap dealer is not acting as an advisor to the Borrower with respect to the recommended derivative or strategy. For purposes of determining whether the swap dealer is acting as an advisor, the Borrower will be treated as if it were a “special entity” under the Commodity Exchange Act.
Registered Commodity Trading Advisors. A commodity trading advisor registered under the Commodity Exchange Act, to the extent providing advice related to swaps.
Thus, parties that typically participate in the issuance of municipal securities as part of a financing team, other than a financial advisor, are exempt from being considered to be a Municipal Advisor as long as they act within the limited scope of their particular duties, as defined by the SEC. However, if any of those parties acts outside the limited scope or provides advice when a Borrower is not acting with regard to municipal financial products or the issuance of municipal securities, such persons could be considered to be acting as a Municipal Advisor and subject to the requirements of the Rule.
The Rule also provides exceptions from the prohibition from persons who are not Municipal Advisors engaging in municipal advisory activities under certain specified circumstances, described below.
Responses to RFPs/RFQs. Any person providing a response to a request for proposals or qualifications from a Borrower for services in connection with a municipal financial product or the issuance of municipal securities, as long as such person does not receive separate compensation for such advice.
Advice Regarding Certain Investment Strategies. A person providing advice regarding investment strategies or programs for the investment of funds that are not the proceeds of municipal securities or the recommendation of and brokerage of municipal escrow investments.
Certain Solicitations. Solicitations that do not relate to providing advice regarding the investment of the proceeds of municipal securities or the recommendation of and brokerage of municipal escrow investments.
Participation by a Registered Municipal Advisor. If a Borrower is represented by an independent registered Municipal Advisor (also known as an “IRMA”) with respect to the same aspects of municipal advisory activities, a person may provide municipal advice as long as all of the following conditions are met:
A registered Municipal Advisor is providing advice to the Borrower with respect to the same aspects of municipal financial product or issuance of municipal securities and within the last two years was not associated with the person seeking to rely on this exemption.
The person relying on this exemption receives from the Borrower in writing a statement that the Borrower is represented by an IRMA and the person can reasonably rely on such representation.
The person providing such municipal advice discloses to the Borrower that it is not a Municipal Advisor and, with respect to municipal entities, it is not subject to the fiduciary duty applicable t Municipal Advisors, and provides a copy of such disclosure to the IRMA.
Such disclosure must be made at a time and in a manner that allows the Borrower to assess the material incentives and conflicts of interest that the person seeking to rely on this exception may have.
Standards Applicable to Municipal Advisors
The most important requirements applicable to Municipal Advisors are that such persons must be registered with the SEC in order to provide advice to Borrowers and they owe a fiduciary duty (to a municipal entity) or a lesser duty of care (to an obligated person). These duties preclude a Municipal Advisor from serving in a role that would be adverse to the client. For example, if a person provides “advice” to a Borrower regarding the issuance of municipal securities, then that person may not serve as an underwriter of such securities. Accordingly, an underwriter that calls on a client or prospective client must be careful not to provide “advice” regarding the issuance of municipal securities, because doing so would cause the underwriter to be a Municipal Advisor to the Borrower and could preclude it from serving as an underwriter for that bond issue. Certainly, where a traditional financial advisor/Borrower client relationship exists, such duties can provide additional protection for the Borrower. However, market participants may be wary of providing information to potential Borrowers, due to the fear that they will either be providing illegal advice as an unregistered Municipal Advisor, or that they will be barred from serving the Borrower in a later financing.
How Could the Rule Affect Borrowers and Other Parties?
Some consequences of the Rule may disadvantage Borrowers. The Rule may restrict the flow of information provided to Borrowers by participants in the municipal securities marketplace that are not Municipal Advisors. Prior to the implementation of the Rule, broker-dealers, underwriters, counsel, and other participants in this market would often call upon clients and potential clients and explore specific or conceptual alternatives for structuring issues of municipal securities and/or related investment. Many investment banks maintain large databases of the securities issued by Borrowers that allow the bankers to provide refunding analyses. Although the Rule and the FAQ would allow provision of factual information by an underwriter to a Borrower without being considered a Municipal Advisor, the kinds of customized analyses that some bankers currently provide to Borrowers could easily cross the line and cause the banker and the firm to be a Municipal Advisor. This is especially the case where a banker presents a proposed restructuring of a maturity schedule in a refunding or a complex model that is designed to meet the needs of a particular Borrower.
Other market participants also may be unwilling to provide information that could be construed as “advice”. For example, many counsel are asked to consider various proposed scenarios for a debt issuance. Although a Borrower’s counsel is free to provide legal advice regarding such structures, (such as whether they are permissible under the law applicable to the Borrower and the tax consequences of various alternatives), counsel that assist a Borrower in developing those analyses or alternatives run the risk of being considered a Municipal Advisor. Although counsel owe their clients duties of care and loyalty in most jurisdictions, counsel could be violating the Dodd-Frank Act if not registered as a Municipal Advisor and “advice” is not legal counsel. Similarly, accountants may be leery of providing advice with regard to how a particular financing alternative could impact a Borrower’s balance sheet, although it should be permissible for an accountant to advise as to how a particular scenario would be treated for accounting purposes. The compartmentalization of the types of information that may be permissibly provided under the Rule may lead to Borrowers receiving less advice or advice that is less well integrated.
Borrowers will likely see more “boilerplate” language in contracts and presentations. All market participants are likely to make extensive use of disclaimers and waivers, as the FAQ indicate that these are at least an indication of the parties’ intent and may provide protection when a facts and circumstances analysis of whether certain communication constitutes impermissible “advice” is performed. Investment bankers are likely to seek pre-engagement letters from Borrowers that permit them to qualify as being exempt from the Municipal Advisor restrictions by being engaged as an underwriter by a Borrower. The FAQ appear to permit this approach, but do not provide details.
The Rule will likely result in significant changes to investment-bank business models. Firms that relied upon tailoring a solution for a Borrower’s unique requirements for marketing their services will be at a disadvantage, as they will have difficulty providing examples of proposed structures before being engaged. Investment Banks that are less well-known may find it harder to demonstrate their qualifications without calling on potential clients and providing tailored solutions.
Lastly, Borrowers will in some cases find that their chosen underwriter has been disqualified because a banker inadvertently provided “advice” and therefore, cannot serve as an underwriter for the bond issue. The impact on the Borrower would be most significant were the inadvertent action discovered late in the bond-issuance process.
Suggestions for Maintaining a Flow of Information and Responding to the Rule.
To maintain a flow of information and protect themselves from the adverse impacts of the Rule, both Borrowers and other market participants may want to consider taking certain affirmative steps by the July 1, 2014 effective date of the Rule. The Rule appears to favor larger Borrowers with the resources either to engage an IRMA or to monitor the market with their own staff. However, there is no exception under the Rule for sophisticated Borrowers, and all participants in the municipal securities market may take certain steps to maintain a flow of information while complying with the Rule.
Take Advantage of the IRMA Exception
The simplest and most effective means to keep information flowing from market participants is for a Borrower to engage an IRMA. In addition, a Borrower may wish to provide notice, either generally, such as through a posting on its website, or specifically by written notice to other participants in the municipal securities marketplace, that the Borrower has engaged a specified IRMA. Such notice should include the names of the principal persons associated with the Municipal Advisor that are assigned to represent the Borrower so that market participants can confirm that they are “independent”, a summary of the IRMA’s scope of services, and provide the IRMA’s mailing address so that interested market participants can provide the Municipal Advisor with the written notice required under the IRMA exception.
One drawback to the use of the IRMA exception is that some market participants may be uncomfortable sharing proprietary information, such as unique structuring concepts, with both the Borrower and its IRMA. According to the FAQ, a Borrower that is represented by an IRMA need not include the IRMA in its meetings with other market participants, and a Borrower may also wish to agree to keep original materials provided by underwriters and others confidential (to the extent permitted by law), reserving the right to share with its IRMA concepts that the Borrower wishes to explore further.
A Municipal Advisor may wish to take advantage of the Rule by offering to provide a specified set of services, such as review of a certain number of proposals, for a regular, but relatively modest retainer, so that the Borrower can have the benefit of both the IRMA exception and the Municipal Advisor’s review of proposals, and the Municipal Advisor can be positioned to assist with a financing when the Borrower decides to enter the market.
Monitor the Market
Another means to keep information flowing is for a Borrower to actively monitor the municipal securities market and its own debt, so that the Borrower can be aware of trends and potential refunding opportunities. A Borrower can undertake an RFP/RFQ process for underwriters (and other financing team members) when conditions are looking more favorable for a refunding and/or a new-money issuance, and include in the materials requests for responses to certain structuring questions, such as a refunding analysis or alternative financing ideas. However, this means that a Borrower will have to use Staff or a Municipal Advisor to do so and may not be able to act fast enough to enter the market when desired.
Engage Team Early
A Borrower that anticipates entering the market will likely wish to engage its financing team earlier in the process than it might currently. Once team members are engaged, they may provide advice within the scope of their engagement. This step allows a Borrower to obtain input from team members (to the extent permitted by the Rule) on structuring issues, and makes it easier to go to the market at an opportune time.
Seek and Provide General Market Information
According to the FAQ, general, factual information such as indicative rates, a summary of recent transactions, and the like are not “advice” and may be provided to a Borrower without running afoul of the Rule. A Borrower may wish to seek several sources of “general” information to obtain a richer view of the market conditions and trends.
Market participants may wish to consider developing forms of such materials and seek ways to disseminate them widely, such as through a regular blog, as well as through direct email or other means to Borrowers. Those persons providing such information should include a standard disclaimer that the materials provided are general and factual in nature and are not intended to be a recommendation of any particular course of action and that by accepting and reviewing such materials, no relationship of Municipal Advisor is created with the recipient of such materials. Such materials should not be particularized to reflect any Borrower’s specific needs, objectives or circumstance, and in no case should such materials include recommendations for Borrowers to take any action or provide tailored alternative structures.
Market participants who are not Municipal Advisors will likely want to maintain complete files of their communications with Borrowers to demonstrate compliance with the Rule. These files should be archived for a reasonable period of time to provide evidence of compliance.
An Underwriter may wish to develop a form of pre-engagement or early engagement letter that satisfies the parameters of the FAQ. Such a letter would be signed by both the Borrower and the underwriter and may be terminable at will or subject to certain conditions. It should clearly relate to providing underwriting services, state the role of the underwriter in the transaction, and be tailored to a specific transaction (rather than constitute a general undertaking), be entered into at or before the time that the underwriter provides any “advice” and the G-17 letter required by MSRB rules when underwriters are engaged. It would be helpful to state that the underwriter is not a Municipal Advisor, that the underwriter and the Borrower have differing interests, and that the underwriter does not owe the Borrower a duty of care or a fiduciary duty.
Almost certainly, the law and regulations relating to the Rule will evolve over time as the SEC and MSRB issue additional guidance, trade groups work to develop standard, industry-accepted forms of materials, and the SEC takes enforcement actions. All market participants, not simply Municipal Advisors, would be wise to follow these developments. In addition, market participants will want to consult with counsel before taking any action relating to the Rule, including development of standard disclaimers for use on marketing materials, internal policies or engaging members of a financing team. As described above, the consequences of failing to comply with the Rule can be significant for all market participants, including Borrowers.