Investment Banks Face Challenges Under New Municipal Advisor Rules
Responding to a perceived gap in the regulatory framework, as well as losses experienced by certain municipalities during the financial crisis, Congress adopted as part of the Dodd-Frank Wall Street and Consumer Protection Act amendments to the Securities Exchange Act of 1934 (the Exchange Act) that create a new registration and regulatory scheme for "municipal advisors."
The law requires municipal advisors to register with the Securities and Exchange Commission (SEC) and comply with the rules of the Municipal Securities Rulemaking Board (the MSRB), including its registration requirements.1 It also imposes on municipal advisors a fiduciary duty when advising municipal entities.
While the law affects virtually all providers of financial services to the municipal sector, the fiduciary duty provision poses a particular challenge for investment banking. For example, where a fiduciary duty attaches, it could limit, or preclude altogether, acting as a principal on the other side of a transaction with a municipal entity, such as acting as a dealer or underwriter. While the statute recognizes these concerns by including several exclusions from being considered a municipal advisor, the scope and contours of these provisions are not clear in the text of the law.
The SEC addressed some of the issues affecting investment banking in its final municipal advisor registration rule (the Final Rule), which was issued on Sept. 18, 2013.2 However, there remain uncertainties that may require further guidance from the SEC and the MSRB. Moreover, it is likely that the municipal advisor requirements will drive significant changes in market practices within municipal investment banking, irrespective of any further regulatory guidance that may be forthcoming.
Municipal Securities Issuance and the Underwriter Exclusion. Among other triggers, a person is a municipal advisor if they provide "advice" to or on behalf of a municipal entity or obligated person3 with respect to the issuance of municipal securities, municipal derivatives, plans or programs for the investment of proceeds of municipal securities or municipal escrow investments.4 Absent an available exemption, a communication to a municipal entity that includes advice on the structure, timing or terms of an issuance of municipal securities generally may only be engaged in by a registered municipal advisor, and would be subject to a fiduciary duty.
Of course, underwriters of municipal securities regularly engage in these sorts of communications with their municipal entity clients. On the one hand, municipal entity clients want to know their underwriter's view and recommendations for their transaction structure. On the other hand, an underwriter purchases securities from its municipal entity client as principal and must negotiate at an arm's length and also must consider the interests of investors. By definition, an underwriter that acts as an issuer's advisor is conflicted, making it essentially impossible for the underwriter to be a fiduciary to the municipal entity. As a result, investment banking firms that engage in underwriting must make sure that they are excluded or exempt from being considered their municipal entity client's municipal advisor, even if the firm is already registered as a municipal advisor.
Congress sought to resolve this conundrum by adopting an exclusion from the definition of "municipal advisor" for any broker, dealer or municipal securities dealer serving as an underwriter (the Underwriter Exclusion). The Final Rule, however, narrowed the Underwriter Exclusion by specifying that it only applies with respect to underwriting a "particular issuance of municipal securities" and only with respect to activities "within the scope" of that underwriting. In the Adopting Release, the SEC further explained that the Underwriter Exclusion applies only once an underwriter has been engaged on a particular transaction and terminates at the end of the underwriting period. In addition, the SEC interprets the Underwriter Exclusion to not apply to certain incidental or ancillary advice or services that many underwriters have historically provided. As a result, absent another exemption, underwriters effectively cannot provide these services.
As described below, prospective underwriters of municipal securities must consider carefully: (i) whether communications with an issuer constitute "advice;" (ii) when the firm is considered to be "engaged" as an underwriter and therefore eligible to rely upon the Underwriter Exclusion; (iii) what types of advice may be given within the scope of the Underwriter Exclusion; (iv) what other exemptions and exclusions may be available with respect to advice; and (v) what requirements and disabilities attach to having given advice, such as registration and compliance requirements and fiduciary and other duties
"Advice." Determining whether a particular communication is "advice" requires a "facts-and-circumstances" analysis. In general, a communication would generally constitute "advice" if it includes any recommendation, especially if it is particularized to the specific needs of a municipal entity or obligated person. Bankers may try to avoid giving "advice" by limiting the information that they provide to municipal entity and obligated person clients to factual and generalized information. Investment banks may also attempt to provide, as part of a facts-and-circumstances "context," disclaimers, disclosures and written notifications clarifying that the investment bank is not giving advice.
Becoming Engaged as an Underwriter. In order to qualify for the Underwriter Exclusion, a broker-dealer or municipal securities dealer must be "contractually engaged" to serve as an underwriter for a particular securities offering. Market practice does not currently entail underwriters being "engaged" until they actually agree to purchase the securities. A bond purchase agreement or underwriting agreement, however, is not executed until late in the process—well after advice that would benefit from the Underwriter Exclusion (such as transaction structuring advice) has been given.