SEC Approves New Rule Codifying Principle-Based Rule and Interpretive Notices; SEC Approves Incorporation of Requirements in Suitability Determination.
On March 7, 2014, the Municipal Securities Rulemaking Board (MSRB) received approval from the Securities and Exchange Commission (SEC) to consolidate extensive interpretive guidance on the fair-practice obligations of municipal securities dealers into three new rules and amendments to an existing rule. Rules focused on Time-of-Trade Disclosures to investors, dealers’ dealings with sophisticated municipal market professionals and suitability of dealers’ recommendations of municipal securities transactions will be effective July 5, 2014.
Whether you are a Compliance Professional charged with protecting your firm and their employees, an Advisor interfacing with retail clients or someone working with non-SMMPs, these clarified rules should be welcome as the guesswork around “what information to disclose and communicate” has been clarified.
This paper focuses on the content and nuances of the new rules around Time-of-Trade Disclosure, the amended rule regarding suitability and explores how technological innovation has and will impact compliance and business practices.
A.Time-of-Trade Disclosure
1.New Rules Actually Make Things Easier For You
While many fret with the introduction of new rules and amendments to existing rules, both the MSRB and SEC have made clear that their objective is to help those who want to comply with the rule. The SEC’s Release (Release No. 34-71665) provides that:
Rule G-47 is designed to consolidate most of the previously issued guidance into rule language which the MSRB believes would ease the burden on dealers and other market participants who endeavor to understand, comply with and enforce these obligations.…[t]he MSRB maintained that the codification is an effort to consolidate the current obligations into streamlined rule language. Emphasis supplied.
Interestingly, the above quote from the SEC mirrors, in large part, the language the MSRB highlighted in its Request for Comment on Codifying Time-of-Trade Disclosure Obligation (February 2013 Notice 2013-04):
…ease the burden on dealers and other market participants who endeavor to understand, comply with and enforce the Time-of-Trade Disclosure Obligation.The new rule delivers as billed although, as discussed below, one must continue to assess the efficacy of their policies and procedures as clarification is provided and technology continues to make material information more reasonably accessible.
1.Introduction to the New Time-of-Trade Disclosure Obligations
Rule G-47 is a codification of the interpretive guidance on Time-of-Trade Disclosure Obligations that were part of MSRB Rule G-17. This codification is part of the MSRB’s effort to review its rules and, in this case, clarify the obligations of those interfacing with retail clients and non-SMMPs in the municipal space. In addition to the MSRB’s stated purpose, protection of the retail investor has been and continues to be a priority of the SEC, FINRA and the MSRB.
G-47 provides, in part, as follows:
No broker, dealer, or municipal securities dealer shall sell a municipal security to a customer, or purchase a municipal security from a customer, whether unsolicited or recommended, and whether in a primary offering or secondary market transaction, without disclosing to the customer, orally or in writing, at or prior to the
time-of-trade, all material information known about the transaction, as well as material information about the security that is reasonably accessible to the market. G-47(a); SEC Release No. 34-71665. Emphasis supplied.
2.Details Worth Noting
a.Application of the Time-of-Trade Disclosure Requirement
The “Time-of-Trade Disclosure” applies to both the sale to and purchase from a customer. The “purchase from” was a step further than many had contemplated under G-17 and its interpretive guidance.In response to comments submitted during the rule-making process, the MSRB added the following sentence to clarify that whether the customer is purchasing or selling is a factor that can be considered in making the materiality determination:
“Whether the customer is purchasing or selling the municipal securities may be a consideration in determining what information is material.” G-47, Supplementary Material: .01(d).
G-47 makes clear that the “Time-of-Trade Disclosure” obligation extends to recommended and unsolicited orders as well as primary and secondary market transactions. In other words, in all situations where a municipal bond is traded for, or on behalf of, a retail client or non-SMMP proper disclosure, as provided for in G-47, is required.
a.Material Information that is Reasonably Accessible
G-47(a) speaks to material information that is reasonably accessible to the market. Information is considered material if:
…there is a substantial likelihood that the information would be considered important or significant by a reasonable investor in making an investment decision. Rule G-47(b) (ii).
This provision seems to leave open, to an extent, what a reasonable investor would consider “important or significant” for purposes of their investment decision. G-47’s non-exhaustive list of examples of disclosure obligations in specific scenarios provides insight as to what may be important or significant. See G-47, Supplementary Material: .03.
The “Time of Trade Disclosure” obligation also requires the disclosure of material information that is reasonably accessible to the market. Accordingly, one must have an understanding of what it means for information to be “reasonably accessible to the market.” In this next section, we explore the explicit language of Rule G-47 as well as the reality that this requirement, by its very nature (and past language from the regulators) is evolutionary.
Rule G-47(b) provides that information is “reasonably accessible to the market where the information is made available publicly through established industry sources” and goes on to define “established industry sources:”
(i) “Established industry sources” shall include the MSRB’s … (“EMMA”) system, rating agency reports, and other sources of information relating to municipal securities transactions generally used by brokers, dealers, and municipal securities dealers … G-47(b)(i). Emphasis supplied.
Importantly, this language explicitly supports the notion that one must go beyond a rating report or EMMA in order to identify and disclose information that is reasonably accessible.
This notion is further supported by the MSRB’s 2012-16 Notice and the SEC filing itself. The 2012-16 Notice specifically recognized the importance of technological enhancements to the advancement of disclosure and transparency:
The MSRB expects that, as technology evolves and municipal securities information becomes more readily available, new “established industry sources” are likely to emerge.
This pronouncement, coupled with language from FINRA’s Regulatory Notice 10-41 regarding “established industry sources” and “material information about the security that is reasonably accessible to the market”, is instructive.
In meeting these disclosure, suitability … obligations, firms must take into account all material information that is known to the firm or that is available through “established industry sources,” … Resources outside of EMMA may include press releases, research reports and other data provided by independent sources … Therefore, firms should review their policies and procedures for obtaining material information about the municipal securities … Emphasis supplied.
Technological evolution and the emergence of new sources is critical as one contemplates the reality that the obligation was and is to “disclose material information that is reasonably accessible.” What was “reasonably accessible” even a year or two ago has changed. Technology has evolved as have the ways in which to ensure your firm’s practices are in line with its policies.
Technology brings to the fore two realities. First, it has made more and better information available. As noted above, what is “reasonably accessible” today is very different than what fit this category one, three or five years ago. Ask yourself:
-Do those dealing with your retail clients have real-time access to material information for communication to the client at or before the time-of-trade?
-Is the information current?
-Is the information in one place for ease of use and delivery?
-Can you verify all the required information was disclosed?
-Can you efficiently access information to answer the question of whether the material information was disclosed at or before the time-of-trade?
As one ponders the above questions, it is worth considering, with the introduction of enhanced technology, is “checking the box” really the best way to demonstrate or document your firm’s policies are indeed practiced, especially as regulators speak more about documentation and proof of action? To this point, at the March 11, 2014, FINRA Conference in New York, we routinely heard about the importance of documentation with one presenter commenting that he was told “if you can’t document that it happened, it didn’t happen.”
Second, FINRA and the SEC have made clear that technology, coupled with data examination and review, will be an important part of the examination and enforcement protocol. They now have the data and technology to better identify the types of activity that may be riskier based on market or individual behavior and focus their examination in ways previously not available.
Combine the advances in technology with the reality that there is clarification around what is required to be disclosed and you have a changed landscape in terms of what is available and what is to be disclosed.A read of G-47 makes clear that a simple review of past material event disclosure filings or an OS summary from the time of issuance will fall short of “material information reasonably accessible.”
Current market conditions and the introduction of a clarified rule should be cause for a re-examination of policies, procedures and what is actually being done. Rule G-47, covered in detail above, enables the regulator and enforcement arm to dismiss the defense of “the rule was less than clear” and “I thought checking the box was enough.” Additionally, interest rate, credit and liquidity risk calls into question what was disclosed to the client at the time-of-trade about the bond and the risks associated therewith.
One may also want to consider whether or not they can “prove” or document that the disclosure was made. While G-47, a codification of G-17 and its interpretive guidance, is silent on the subject of requiring proof, the subject of being able to document what has been done has been the topic of discussion at several forums and most recently was cited by several participants at the FINRA New York Conference cited above. Proof may be a good thing to have when one is asked to prove disclosure was made. When put to the test – either an examination or complaint – would you prefer the “he said, she said” approach, or something more?
1.New Rule Requires a Review of Policies, Procedures and Practices
The introduction of a new Rule with an effective date of July 5, 2014 would seem to be a warning shot across the bow for firms and their professionals to undertake a thorough review of their policies, procedures and actual practices – are those interacting with retail investors and non-SMMPs providing proper disclosure to the retail client and are you documenting it? Those seeking to embrace policies, procedures and practices consistent with the language and spirit of G-47 should ensure their approach supports transparency and disclosure of “material information about the security that is reasonably accessible to the market.” In this regard, it is important to consider continued advancements in technology and information availability (just as the SEC and FIRNA does). Consider, at a minimum, an annual review of policies, procedures and tools available to support compliance.
Suitability
The SEC-approved amendment to G-19 focuses on the reasonable-basis obligation and provides, in pertinent part:
(a) The reasonable-basis obligation requires a broker, dealer or municipal securities dealer to have a reasonable basis to believe, based on reasonable diligence, that the recommendation is suitable for at least some investors… [R]easonable diligence must provide … an understanding of the potential risks and rewards associated with the recommended municipal security… and an understanding of information about the municipal security …, including the information described in MSRB Rule G-47 (Time-of-Trade Disclosure), to the extent such information is material. The lack of such an understanding when recommending a municipal security or strategy violates the suitability rule. Emphasis supplied.
The importance of the requirements of Rule G-47 go beyond Time-of-Trade Disclosure and form a foundational aspect of one of the three legs of the stool to support a suitability determination.
A.What Do I Need to Disclose
As noted above, the objective of G-47 is to codify a principle-based rule with extensive interpretive guidance into something that addresses the concerns of market participants. G-47 maintains a basic premise embodied in G-17 – disclosure of material information reasonably accessible – and also sets forth a non-exhaustive list of examples of “information that may be material in specific scenarios and require Time-of-Trade Disclosures to a customer.” G-47 makes clear that “… other information may be material to a customer in these and other scenarios.” Thus, “material information reasonably accessible” remains the standard.
1.Disclosure of Investment-Specific Risk
G-47 makes clear the importance of disclosing risk factors specific to the investment. Supplementary Material, .01(a) makes clear that:
[t]he disclosure obligation includes a duty to give a customer… facts that are material to assessing the potential risks of the investment.
Facts material to assessing potential risks seem to incorporate the potential risks of a given investment: think credit, interest rate, liquidity, market and other risks. While some firms have taken to delivery of such information once a year, one has to contemplate the efficacy of such an approach when the requirement is for disclosure specific to a particular security at or before the time-of-trade.
2.What is Not Acceptble :
The Supplementary Material for G-47 matter-of-factly lets us know what is not acceptable to satisfy the disclosure obligation.
•The public availability of material information through EMMA, or other established industry sources, does not relieve brokers, dealers, and municipal securities dealers of their obligation to make the required Time-of-Trade Disclosures to a customer.
•A broker, dealer, or municipal securities dealer may not satisfy its disclosure obligation by directing a customer to an established industry source or through disclosure in general advertising materials. Supplementary Material .01(b) © .
B.Steps To Consider to Meet Your Time-of-Trade Disclosure Obligation
Let’s start with the fact that the Supplementary Material provides that “… dealers must implement processes and procedures reasonably designed to ensure that material information regarding municipal securities is disseminated to registered representatives who are engaged in sales to and purchases from a customer.” Supplementary Material .04. You then must have policies and procedures to ensure that the material information that is disseminated to your representatives is communicated to your clients – both retail and non-SMMP.
This section focuses on three alternatives to address the requirements of G-47. As you contemplate the Time-of-Trade Disclosure requirement, consider the evolutionary nature of the technology and the cost-benefit of the alternatives.
1. EMMA Plus Some Work
There is a “go it alone” approach – EMMA, rating agency reports, and “other sources of information relating to municipal securities transactions generally used by brokers, dealers, and municipal securities dealers that effect transactions in the type of municipal securities at issue.” In considering this approach, contemplate the time associated with gathering all of the required information, the creation of a consistent approach to regularly access the same and the development of a construct to ensure the information is delivered (documentation). Based on our research and market feedback, it can take up to 30minutes per trade to access the various sources and identify “material information about the security that is reasonably accessible to the market.”
If you opt for this approach, as suggested by G-47, a good place to start is EMMA. From there, it is up to you to find the right way to satisfy the obligation. Should you choose to pursue this path be sure to contemplate a process for documenting all you do and storing the same.
2. The Advisor Platform
DIVERAdvisorwas created to address the Time-of-Trade Disclosure Obligation for municipal bonds. The need for the platform was identified by market participants who recognized that technology can be used to address the time-consuming requirements around this obligation. These same market participants suggested there was a need for a tool to support compliance before the FINRA examination so that advisors and the firm were protected.
The Advisor platform addresses Time-of-Trade Disclosure Obligations by producing, for every municipal bond, a report that is ready for client delivery. The report is produced in seconds, can be easily delivered to clients and is supported by a robust compliance reporting engine. Each “Municipal Bond Report” brings together information to support the Time-of-Trade Disclosure Obligation and includes custom risk factors, geo-located news links for every bond and sector-based economic and demographic data to help understand the critical factors that drive the fiscal well-being of the Issuer. “Material information about the security that is reasonably accessible to the market” –providing business efficiencies and documentation that you accessed and delivered the same.
The Advisor platform, made fully available in April 2013, was presented to the regulator for comments and feedback and, as demonstrated by the more than 29,000 subscribers, has been embraced by market participants.
3. Tools Designed to Meet Other Needs
With the introduction of G-47 as a final Rule, practices deemed “good enough to get by” need to be revisited to ensure that “square peg in the round hole” practices/solutions do, in fact, satisfy G-47. While many of these practices are effective for the purpose for which they were created or may satisfy part of the obligation – a summary of the Official Statement or a list of Continuing Disclosures – they do not appear to satisfy the obligations under G-47 (revisit that OS summary and determine if it is current; are you sure news stories identified by a third party capture information your firm may deems material?). Material information reasonably accessible, with today’s technology, is much more expansive.
In considering such tools, also take into account the question of efficiency and the ability to effectively disseminate the information to the retail client. Lastly, for those opting to address the mantra of “documentation,” does your solution or a patch-work approach provide you the documentation you need to support that the disclosure was actually made?
Conclusion: Clarified Obligations May Lead to More Penalties
Now that G-47 has been approved and its effective date looming, do your policies, procedures and practices meet the requirements? Advances in technology and clarity around the Time-of-Trade Disclosure Obligation for your non-SMMP and retail client are cause to revisit your policies and actual practices. Have you kept up with technology, or will the regulator be a step ahead? Can you document that disclosure has been made?
As protection of the retail and non-SMMP investor continues to be of paramount importance, one can make a strong argument that the clarified obligations may result in increasingly significant penalties for those firms that do not take the necessary steps to shore-up existing policies, procedures and tools to address Time-of-Trade Disclosure Obligations.
Sources and Related Documents :
- SEC Order Granting Approval of a Proposed Rule Change Consisting of Proposed MSRB Rule G-47, on Time of Trade Disclosure Obligations, Proposed Revisions to MSRB Rule G-19, on Suitability of Recommendations and Transactions, Proposed MSRB Rules D-15 and G-48, on Sophisticated Municipal Market Professionals, and the Proposed Deletion of Interpretive Guidance.http://www.sec.gov/rules/sro/msrb/2014/34-71665.pdf
MSRB Regulatory Notice 2014-07, March 12, 2014. Regulatory Notice
Muni Time-of-Trade Disclosure - Why a New Rule and Why the Delay? February 11, 2014. http://www.lumesis.com/pdf/Final-Time-of-Trade-Disclosure.pdf
Retail Client Time-of-Trade Disclosure: "New" Rules on the Way…Are You Prepared? September 26, 2013. http://www.sifma.org/thought-leader-library/2013/retail-client-time-of-trade-disclosure--new-rules-on-the-way---are-you-prepared-/
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