Why should banks worry about new municipal advisor regulations? This question is of particular importance to community banks that do not engage in underwriting or brokering municipal securities and therefore believe (logically), that they could not possibly be a “municipal advisor.” But, many community banks hold significant deposits of municipal entities, extend credit to municipalities or enter into interest rate swaps with municipal entities and discuss all of those products and services extensively with the municipal entities. As discussed below, such business dealings may, in some cases, bring the bank within the scope of the new municipal advisor registration regime. Under that regime, municipal advisors are subject to extensive and demanding fiduciary duties to the municipalities they advise as well as anti-fraud standards.
No banking exemption. Neither Dodd-Frank nor the Security Exchange Commission’s release adopting the new temporary rule includes any exemption for the activities of banks related to municipal deposits, loans to municipalities or interest rate swaps with municipalities. Industry comments on this rule, such as those from The Financial Services Roundtable and the Independent Community Bankers of America, have clearly expressed to the Securities Exchange Commission (SEC) the need to exempt banks from municipal advisor status. Without such an exemption, several of the definitions are broad enough to include a range of traditional banking services and products, such as interest rate swaps, cash management, deposit and lending activities and trust and custody services. There are compelling arguments for such an exemption, including the fact that Section 975 of Dodd-Frank appears aimed at unregulated institutions and the longstanding regulatory tradition of allowing bank regulators exclusive authority to regulate and examine traditional banking activities. But for now, no such exemption exists.
Definition of “municipal advisor.” In relevant part, the Securities Exchange Act of 1934 (the “Exchange Act”) now defines a “municipal advisor” as:
(A) a person . . . that
(i) 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, including advice with respect to the structure, timing, terms, and other similar matters concerning such financial products or issues; or
(ii) undertakes a solicitation of a municipal entity;
(B) includes financial advisors, guaranteed investment contract brokers, third-party marketers, placement agents, solicitors, finders, and swap advisors, if such persons are described in any of clauses (i) through ([ii]) of subparagraph (A); and
(C) does not include a broker, dealer, or municipal securities dealer serving as an underwriter . . ., any investment adviser . . . who are providing investment advice, any commodity trading advisor . . . who are providing advice related to swaps, . . .
Understanding the phrase “provides advice to.” One needs to read both the statutory definition of “municipal advisor” and Form MA-T for the most complete description of the types of advisory services that will make a bank a municipal advisor. The following is a list based on the statutory language and the language in Form MA-T:
- advice with respect to municipal financial products (municipal derivatives, guaranteed investment contracts, and investment strategies ), including advice with respect to the structure, timing, terms, and other similar matters concerning such financial products;
- advice with respect to the issuance of municipal securities, including advice with respect to the structure, timing, terms, and other similar matters concerning such issues;
- advice concerning the investment of the proceeds of municipal securities;
- recommendation and/or brokerage of municipal escrow investments;
- advice concerning the use of municipal derivatives (e.g., swaps);
- solicitation of business from a municipal entity or obligated person for an unaffiliated person or firm (e.g., third-party marketers, placement agents, solicitors and finders), and
- preparation of feasibility studies, tax or revenue projections, or similar products in connection with offerings or potential offerings of municipal securities.
If a bank is providing any of the above types of advice, recommendations or analysis to municipal entities, then the bank likely is a municipal advisor, at least for purposes of SEC-administered law and regulation.
Generally, commercial loans of the sort that community banks make do not fit the definition of municipal financial products, so the bank’s discussions with a municipal borrower should not make the bank a municipal advisor. Nor do most commercial loans fit the definition of “security” under the securities laws, so the making of such a loan should not constitute the issuance of a municipal security. Interest rate swaps do fit the definition of a municipal financial product, which means banks should be careful in approaching such transactions with a municipal entity. Likewise, deposit accounts and cash management products and discussions surrounding them could be covered by the municipal advisor definitions. In some cases, an appropriate acknowledgement form may be appropriate before these discussions are initiated to ensure, as best can be done currently, that the bank is not deemed to be providing advice to the municipal entity.
Registration of municipal advisors. Section 975 of Dodd-Frank amended Section 15B(a) of the Securities Exchange Act of 1934 (the “Exchange Act”) to forbid a “municipal advisor” from “provid[ing] 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 to undertake a solicitation of a municipal entity or obligated person, unless the municipal advisor is registered [with the SEC].” That registration requirement became effective on October 1, 2010.
SEC registration. On September 1, 2010, the SEC adopted, “on an interim final temporary basis,” Exchange Act Rule 15Ba2-6T (17 C.F.R. § 240.15Ba2-6T). The adoption of that Rule was intended to serve as a transitional step to the implementation of a final permanent registration program, to make information available to public and municipal entities, and to allow municipal advisors to continue their business after October 1, 2010. Municipal advisors can temporarily satisfy the registration requirement by submitting information electronically through the SEC’s website on Form MA-T. The interim temporary rule was to expire on December 31, 2011 but the SEC extended the expiration date for the temporary municipal advisor registration regime to September 30, 2012.
Any bank that decides it should file a Form MA-T must complete the form carefully. It is unlawful for the advisor to willfully make a misleading statement or omit to state a material fact in the Form MA-T and doing so constitutes a Federal crime. Thus, banks must carefully answer the questions for itself and for each of its “associated municipal advisor professionals.” Doing this may require background searches on each of the bank employees that fit the definition. Form MA-T is accessible through a link on the SEC’s website and may not be filed in paper form. The General Instructions and Glossary for the Form provide further instructions and explanation in preparing and filing the form. If the bank has a broker-dealer affiliate, it will recognize the form as very similar to Form BD for broker-dealers.
MSRB registration. In addition to the SEC registration requirements, municipal advisors must register with the Municipal Securities Rulemaking Board (MSRB) on Form G-40. The definition of “municipal advisor” for MSRB purposes is the same as for SEC purposes. MSRB Rules A-12 and A-14 requires municipal advisors to provide identifying information to the MSRB, pay an initial fee of $100 and an annual fee of $500. MSRB Rule G-40 requires a municipal advisor to appoint a primary contact person to receive email communications and to provide periodic updates to the MSRB.
SEC-imposed fiduciary duties. An important consequence of being a municipal advisor is being subject to important fiduciary duties. Dodd-Frank amends Section 15B(c)(1) of the Exchange Act to set forth the following fiduciary duty of municipal advisors:
A municipal advisor and any person associated with such municipal advisor shall be deemed to have a fiduciary duty to any municipal entity for whom such municipal advisor acts as a municipal advisor, and no municipal advisor may engage in any act, practice, or course of business which is not consistent with a municipal advisor’s fiduciary duty or that is in contravention of any rule of the [Board of Governors of the Federal Reserve System].
Note that the fiduciary duty applies whether or not the municipal advisor has registered as such. To date, neither the Federal Reserve nor the SEC has provided further detail or guidance on what fiduciary status will mean for municipal advisors.
MSRB-imposed duties. The MSRB has requested comment on Rule G-36 (still in draft form), which provides as follows:
In the conduct of its municipal activities on behalf of municipal entities, a municipal advisor shall be subject to a fiduciary duty, which shall include a duty of loyalty and a duty of care.
The MSRB has published a draft interpretive notice for Rule G-36. That notice covers in some detail the various obligations under the duty of loyalty (dealing with conflicts of interest via disclosure and informed consent; refraining from unmanageable conflicts and restrictions on compensation). It also explains the duty of care (refraining from engagements for which the advisor is not qualified, a duty of inquiry into the facts relevant to a municipal entity’s decision to proceed with a particular course of action). These duties will require the municipal advisor to engage in careful analysis and to painstakingly document disclosures and the scope of engagement.
In addition, MSRB Rule G-17 (effective December 22, 2010), provides as follows:
In the conduct of its municipal securities or municipal advisory activities, each broker, dealer, municipal securities dealer, and municipal advisor shall deal fairly with all persons and shall not engage in any deceptive, dishonest, or unfair practice.
The MSRB has also published a draft interpretive notice for Rule G-17. That draft interpretation details the obligation of fair dealing, including the obligation to conclude that a recommended course of action is appropriate for the municipal entity, to act with sufficient knowledge, to disclose conflicts, including with respect to certain types of compensation, and obtain informed consent. It also details various forms of deceptive, dishonest and unfair practices. This Rule, like Rule G-16, will require very careful analysis and documentation of each engagement.
Most banks have not registered as municipal advisors. There are risks and regulatory burdens that a bank takes on if it registers as a municipal advisor, although registration as a municipal advisor by itself does not bring a bank’s actions with respect to a particular transaction under the municipal advisor regime. Thus, a bank might register just in case a particular transaction would have triggered the registration requirement.
Because the regulators have not yet granted a clear exemption for banks, one possible path is for banks to prepare a policy for interacting with municipalities and carefully document their interaction with municipal entities and thus demonstrate (to the extent possible) that the bank is not soliciting municipal entities or providing advice to them. If this is done carefully with the input of legal counsel, and not as a subterfuge, then the bank may be able avoid registration entirely. Apparently, most banks have decided not to register, since only about 50 banks have registered with the SEC and about 30 have registered with the MSRB as of late August 2012.
Whether or not a particular bank decides to register as a municipal advisor, the bank should have a strategy and process in place for its interactions with municipal entities, if for no other reason than to know where the boundaries and risks lie.