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Financial Markets Alert

Dodd-Frank Act Expands Authority of the Municipal Securities Rulemaking Board

On July 15, 2010, The Senate passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, which had previously been passed by the House. It has been reported that the President will sign the bill next week.

The Reform Act contains a substantial expansion of the rulemaking authority of the Municipal Securities Rulemaking Board (MSRB). The MSRB was established by Congress under the 1975 amendments to the Securities Exchange Act of 1934 as a self-regulatory organization in connection with broker-dealer transactions in municipal securities and related municipal securities business activities of broker-dealers. Unlike FINRA and the stock exchange self-regulatory organizations, the MSRB was created directly by Congress in section 15B of the 1934 Act, and section 15B(c)(1) specifically provides that any violation of a rule of the MSRB is a violation of law. The provisions expanding MSRB jurisdiction are primarily in Subtitle H, section 975 of the Reform Act and will appear as amendments to section 15B of the 1934 Act.

Prior to the Reform Act, MSRB jurisdiction extended only to broker-dealers and to their transactions in municipal securities. The Reform Act broadened the class of persons covered by MSRB jurisdiction, and rulemaking authority is no longer limited to activities related to municipal securities, but includes transactions in an array of financial products (notably, municipal derivatives and investment contracts) involving "municipal entities" or "obligated persons."

Municipal Advisors

The Reform Act requires that municipal advisors be registered with the SEC, similarly to the registration requirement for broker-dealers. A municipal advisor is defined as a person that, (i) provides advice to a municipal entity or obligated person with respect to municipal financial products or the issuance of municipal securities, or (ii) undertakes a solicitation of a municipal entity. The definition specifically includes financial advisors, guaranteed investment contract brokers, third-party marketers, placement agents, solicitors, finders and swap providers. The definition excludes broker-dealers acting as underwriters and investment advisers registered under the Investment Advisers Act of 1940. The definition also excludes attorneys offering legal advice or providing services that are of a traditional legal nature, and engineers providing engineering advice.

The Reform Act authorizes the MSRB to adopt rules that provide professional standards for municipal advisors (e.g. testing of personnel and supervisory rules), and that prescribe means reasonably designed to prevent acts, practices, and courses of business conduct as are not consistent with a municipal advisor's fiduciary duty to its clients. A municipal advisor is deemed to have a fiduciary duty to any municipal entity for whom such municipal advisor acts as a municipal advisor.

There is an antifraud rule specifically applicable to municipal advisors with respect to: advice to a municipal entity or obligated person, financial products, the issuance of municipal securities or in the solicitation of a municipal entity or obligated person. The Reform Act further provides that no municipal advisor may engage in any act, practice or course of business that is not consistent with the municipal advisor's fiduciary duty or that is in contravention of any rule of the MSRB.

Municipal Financial Products

The Reform Act extends MSRB rulemaking jurisdiction to  regulate transactions by broker-dealers and advice by broker-dealers or municipal advisors concerning municipal financial products, in addition to the MSRB's  traditional rulemaking authority with respect to broker-dealer transactions in municipal securities. A municipal financial product is defined as municipal derivatives, guaranteed investment contracts and investment strategies.

An investment strategy is defined to include plans or programs for the investment of municipal securities, and the recommendation of and brokerage of municipal escrow investments.

A guaranteed investment contract is defined to include any investment that has specified withdrawal or reinvestment provisions and a specifically negotiated or bid interest rate, and also includes any agreement to supply investments on two or more future dates, such as a forward supply contract.

The bill that was reported out by the conference committee deleted the definition of municipal derivatives that had been in the Senate bill. Under S.3217, a municipal derivative had been defined by the Senate in section 975 as "any financial instrument or contract designed to hedge a risk (including interest rate swaps, basis swaps, credit default swaps, caps, floors, and collars)".    It is not clear whether the definition will be reinserted when Congress adopts technical amendments to the bill.

Regardless of the definition of municipal derivatives that is finally applied to MSRB rulemaking authority, the jurisdiction of the MSRB in respect of derivatives is likely to overlap with the new rulemaking authority of the CFTC and the SEC to regulate derivatives. The agencies will have to reach an accommodation with the MSRB on the issues to be covered by MSRB rules.

Solicitation of Municipal Entities and Obligated Persons

The Reform Act grants jurisdiction to the MSRB to adopt rules regulating the use of outside consultants by broker-dealers and municipal advisors who, for compensation, solicit municipal entities or obligated persons for the purpose of  obtaining an engagement of a broker-dealer or municipal advisor for municipal financial products, the issuance of municipal securities, or of an investment adviser to provide investment advisory services to or on behalf of a municipal entity.

Municipal Entities and Obligated Persons

A municipal entity is broadly defined to mean any State, political subdivision of a State, or municipal corporate instrumentality of a State, including: (i) any agency, authority, or instrumentality of the State, political subdivision, or municipal corporate instrumentality, (ii) any plan, program, or pool of assets sponsored or established by the State, political subdivision, or municipal corporate instrumentality or any agency, authority, or instrumentality thereof, and (iii) any other issuer of municipal securities.

The definition of an obligated person is derived from SEC Rule 15c2-12 and is defined in the Reform Act to mean any person, including an issuer of municipal securities, who is either generally or through an enterprise, fund, or account of such person, committed by contract or other arrangement to support the payment of all or part of the obligations on the municipal securities to be sold in an offering of municipal securities. The obligated person definition in the Reform Act does not have the Rule 15c2-12 exclusion for credit providers and liquidity facilities because obligated persons are not regulated under the Reform Act; they, along with municipal entities, are beneficiaries of certain rules regulating broker-dealers and municipal advisors.

The purpose of the definitions of municipal entities and obligated persons is to make clear the beneficiaries of certain of the MSRB rules. For example, section 15B(b)(2) provides that the MSRB is to make rules governing advice to municipal entities or obligated persons by broker-dealers and municipal advisors regarding municipal financial products and the issuance of municipal securities, whereas section 15B(c)(1) makes a municipal advisor a fiduciary to a municipal entity, but not to an obligated person.

Enforcement of MSRB Rules

Prior to the Reform Act, the MSRB was limited to rulemaking, and enforcement of MSRB rules was by FINRA, the SEC, and appropriate bank regulators. The Reform Act extends authority to the MSRB to "provide guidance and assistance in the enforcement of, and examination for, compliance with" MSRB rules to the SEC, FINRA or the appropriate bank regulators. Related sections of the Reform Act require FINRA to adopt rules to request guidance from the MSRB in the interpretation of MSRB rules. Section 979 of the Reform Act, which formalizes the office of municipal securities within the SEC , directs the office to coordinate with the MSRB  for rulemaking and enforcement actions.

MSRB Board Composition

The MSRB Board is composed of 15 persons with three-year staggered terms. Previously, the board was composed of five persons representing broker-dealers, five persons representing commercial banks having municipal finance departments, and five persons representing the public. In the future, the board is to consist of eight public members, at least one of whom is to represent institutional investors and at least one of whom is to represent municipal entities. Of the seven members associated with a broker-dealer and a bank municipal department, or  a municipal advisor (regulated representatives), at least one is to represent broker-dealers that are not banks, at least one is to represent municipal securities dealers that are  commercial banks, departments of banks or subsidiaries of banks, and at least one is to represent municipal advisors.