By Angela W. Adolph

Last week, the Securities and Exchange Commission (SEC) approved new rules regarding the disclosure duties of underwriters to municipal issuers of securities that were proposed last summer by the Municipal Securities Rulemaking Board (MSRB).  The new rules include explicit and expanded requirements for underwriters aimed at protecting municipal issuers. Current rules already prohibit an underwriter from engaging in any deceptive, dishonest or unfair practice with respect to municipal issuers, but the new rules ensure fair dealing with state and local governments and that they have necessary information to make the best decisions when considering undertaking financial transactions. 

Thus, the new rules require underwriters to disclose to municipal issuers the risks associated with complex municipal bond transactions, potential conflicts of interest, and compensation received from third-party providers of derivatives and investments, among other things.  The new rules also provide specific examples of how underwriters must fulfill their obligation.  Some of the new requirements are that:

An underwriter must provide “robust disclosures” as to its role in the transaction, its compensation, and any actual or potential material conflicts of interest.  For example, an underwriter must disclose whether its compensation is contingent upon closing the transaction or the size of the transaction.  If so, it must also disclose that this presents a conflict of interest because it may cause the underwriter to recommend a transaction that is unnecessary or in an amount that is larger than necessary.

All representations made by underwriters to state and local governments must be truthful and accurate and must not misrepresent or omit material facts.  For example, an underwriter’s response to an issuer’s request for proposals or qualifications must fairly and accurately describe the underwriter’s capacity, resources, and knowledge to perform the proposed underwriting.   An underwriter must not represent that it has the requisite knowledge or expertise with respect to a particular financing if its personnel lack the requisite knowledge or expertise. 

Underwriters that recommend complex transactions or products are required to disclose all material financing risks and characteristics, incentives and conflicts of interest.  For example, variable rate demand obligations and derivatives such as swaps are the sorts of complex transactions that would require the underwriter to make this disclosure. The level of disclosure may vary depending on the issuer’s knowledge or experience with the proposed structure.

An underwriter’s duty to have a reasonable basis for its representations to issuers extends to representations made in connection with preparation of disclosure documents.  For example, the underwriter must have a reasonable basis for the representations contained in its closing certificates that will be relied upon by the issuer.

The duty to treat state and local governments fairly requires that compensation paid by the underwriter to the issuer is fair and reasonable in light of all relevant factors.  For example, if the underwriter represents that it is providing the “best” market price or that it will exert its best efforts to obtain the “most  favorable” pricing, its actions must be consistent with those representations.

Underwriters must disclose potential conflicts of interest, such as third-party payments, values or credits, profit-sharing with investors, and credit default swaps.  For example, it would be a violation of the rule for an underwriter to compensate an undisclosed third-party in order to secure municipal securities business, or for the underwriter to be compensated by an undisclosed third-party for recommending that party’s services or products to an issuer.

Underwriters who agree to underwrite transactions with retail order periods must honor those agreements.  For example, underwriters cannot disregard rules for retail order periods by accepting or placing orders that do not satisfy state and local definitions of “retail.”

Underwriters are also reminded to refrain from giving inappropriate gifts, gratuities and non-cash compensation to issuer personnel. For example, underwriters should avoid lavish and excessive travel and meal expenses incurred during rating agency trips and closing dinners.

The notice, which applies only to negotiated underwritings and not competitive underwritings unless specified, becomes effective in August.