For years, regulators have tried to address conflicts of interest in the bond markets to prevent underwriters who advise borrowers from profiting from the products they recommend.
In September 2013, the SEC adopted the so-called MA rule requiring firms that provide advice to register as municipal advisors. This rule will apply to bond underwriters, financial advisors, guaranteed investment contract brokers, and swap advisors.
MSRB Rule G-23 already prohibits firms from serving as advisor then switching hats and serving as underwriter, but that rule was designed to address conflicts and did not define what is considered a municipal advisor.
The new MA rule does define advice, and in the process, captures many of the traditional communications between underwriters and borrowers.
As a result, broker-dealers who want to act as underwriters will need to be very careful in their discussions with borrowers to avoid being considered municipal advisors and prevented from underwriting.
What Constitutes Advice?
The MA rule defines advice as a suggestion or recommendation to buy a municipal financial product or issue municipal securities, if tailored to the borrower’s specific needs.
Under this broad definition, many presentation materials, pitch books and other written and verbal communications from underwriters will be considered advice and require them to register as municipal advisors.
The SEC gives some practical examples:
- A bond underwriter proposes to refinance 30-year, fixed rate bonds. The existing bonds have level annual debt service, but the pitch book shows savings by refinancing with a different debt structure e.g. non-level annual debt service or a different final maturity date. That constitutes advice, says the SEC, because it is specific to the borrower’s situation.
- A bond underwriter pitches a bond issuance with a specific estimate of what rates it thinks it can achieve for the borrower, rather than a range. Because the presentation is customized to the borrower’s specific situation, it constitutes advice.
- A bond underwriter helps a borrower decide whether an event constitutes a “material event” under continuing disclosure rules. Because the discussion is specific to the borrower, it constitutes advice.
Exceptions to the MA Rule
There are four basic exceptions to the MA Rule which permit broker-dealers to advise municipal borrowers without being required to register as municipal advisors:
- General Information Exclusion:
A broker-dealer can present general information such as firm qualifications and a market update, so long as the information is not specific to the issuer/borrower.
- Underwriter Exclusion:
A broker-dealer who is engaged as underwriter is permitted to provide advice related to the bond issue it has been engaged to underwrite, so long as if there is an engagement letter in place which meets SEC requirements.
- RFP Exemption:
A broker-dealer can respond to an RFP if the RFP states specific objectives, is sent to at least three firms or publicly posted, and is not for an indefinite period of time.
- Independent Registered Municipal Advisor ("IRMA") Exemption:
A broker-dealer can pitch ideas to an issuer/borrower if the latter hired an independent registered municipal advisor, represented in writing to the broker-dealer that it will rely on the advisor’s advice, the scope of the advisor’s engagement covers the specific products proposed, and the broker-dealer has provided a written disclosure to the issuer/borrower with a copy to the advisor that the firm is not acting as a municipal advisor and, in the case of an issuer, does not owe a fiduciary duty to the issuer.
Communications which do not fall under one of the above exceptions are considered advice, and will require registration.
Traditional bank loans and other bank products that do not fit the definition of municipal securities or financial products should not require registration. Interest rate swaps to hedge municipal debt, on the other hand, likely fit the definition.
How Hospitals Will be Affected
The MA Rule does not provide penalties for hospitals in situations where underwriters provided advice without registering as municipal advisors, but hospitals may be adversely impacted if they are unable to obtain advice previously received from underwriters.
There are three main options available to hospitals wanting to receive substantive input from broker-dealer firms:
- The most flexible option is to hire an independent registered municipal advisor. Many hospitals have already done this for economic reasons, as a qualified advisor often returns a multiple of fees in various ways. Under the IRMA Exemption, hiring a municipal advisor will allow the hospital to request and receive input from broker-dealers and other market participants at will, provided the proper representations are made.
- The second option is to hire the applicable broker-dealer as bond underwriter, which would allow the underwriter to qualify under the Underwriter Exclusion. The challenge for the hospital is that the engagement must be for a specific transaction. This is a conundrum for hospitals that haven’t yet determined their plan of finance. Another challenge is that broker-dealers that have not been retained for the applicable transaction do not qualify for the exclusion, so the hospital cannot benefit from their advice.
- The third option is to conduct a RFP. This would allow respondents to provide advice under the RFP Exemption, but the RFP period cannot be indefinite: the SEC considers 3 months to be reasonable, so a hospital in need of ongoing advice from underwriters would need to conduct periodic RFP’s. This could become cumbersome for both hospital management and for the broker-dealers responding to the multiple RFP's.
When effective on July 1, we expect the MA rule to have a significant impact on the way hospitals communicate with bond underwriters and other broker-dealers.
We also expect more efforts on the part of broker-dealers to water down the MA rule or at least postpone its implementation.
In the meantime, hospitals and other municipal borrowers should review the way they interact with bond underwriters and determine the best way to deal with the coming regulatory changes.
SEC Final Rule on Municipal Advisor registration: http://www.sec.gov/rules/final/2013/34-70462.pdf
SEC FAQs: http://www.sec.gov/info/municipal/mun-advisors-faqs.shtml
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