The MSRB's Rule G-23, for Financial Advisers, A Classic Example of a Rule That Does Not Rule
The activities of financial advisers are regulated by rule G-23 of the Municipal Securities Rulemaking Board. It is a classic example of a rule that does not rule.
The rule established disclosure and other requirements for dealers that act as financial advisers to issuers of municipal securities. The rule is designed principally to minimize the prima facia conflict of interest that exists when a municipal securities dealer acts as both financial adviser and underwriter with respect to the same issue. Specifically, it requires a financial adviser to alert the issuer to the potential conflict of interest that might lead the dealer to act in its own best interest as underwriter rather than the issuer's best interest.
Early in 1991, the MSRB board was asked whether rule G-23 applies in two situations: when a non-dealer bank acts as financial adviser and a broker-dealer affiliate of the bank wishes to underwriter the issue; or when a non-dealer subsidiary of a dealer bank acts as a financial adviser and the dealer bank wishes to underwrite the issue. These questions were raised by the National Association of Independent Public Financial Advisors.
MSRB responded by adding paragraph (e) to its regulation. This paragraph reads as follows:
"(e) Disclosure to Issuer of Corporate Affiliation. If the financial adviser for the issue is not a broker, dealer, or municipal securities dealer, and the broker, dealer, or municipal securities dealer that acquire the issue or arranges for such acquisition pursuant to section (d) of this rule is controlling, controlled by, or under common control with such financial adviser, the broker, dealer, or municipal securities dealer must disclose this affiliation in writing to the issuer prior to the acquisition and the issuer has acknowledged in writing to the broker, dealer, or municipal securities dealer receipt of such disclosure."
The MSRB went a step further. To dealers covered by both paragraph (d) and the new paragraph (e) are made subject to a new paragraph (f) which reads as follows:
"(f) Each broker, dealer, and municipal securities dealer subject to the provisions of sections (d) or (e) of this rule shall maintain a copy of the written disclosures, acknowledgments and consents required by these sections in a separate file and in accordance with the provisions of rule G-9."
It would appear the NAIPFA made its point. The rule now clearly covers public finance sections of banks, investment bankers and other security dealers under paragraph (d). It also covers financial advisers who are separate corporations owned by a dealer, bank or underwriter or are in any other way affiliated with a bank, security dealer or underwriter.
However, one is cautioned to read the footnotes as well as the rule. Footnote 2 states, ~Rule G-23 does not apply to ~independent' financial advisers: "The rule also does not apply when, in the course of acting as an underwriter, a municipal securities dealer renders financial advice to an issuer, including advice with respect to the structure, timing, terms, and other similar matters concerning a new issue of municipal securities."
It appears that negates all intentions of paragraphs (d), (e), and (f).
Paragraph (d) provides mechanisms for a broker, dealer or municipal securities dealer to serve in both the capacity as financial adviser and the underwriter. If it is a negotiated transaction, three actions must take place:
First, the financial advisory relationship with respect to such issue has been terminated in writing and after such termination the issuer has expressly consented in writing to such acquisition or participation in the purchase of the securities.
Second, the broker or dealer or municipal securities dealer has expressly disclosed in writing to the issuer at or before such termination that there may be a conflict of interest in changing from the capacity of financial adviser to purchaser of the securities with respect to which the financial advisory relationship exists and the issuer has expressly acknowledged in writing to the broker, dealer, or municipal securities dealer receipt of such disclosure. The same paragraph that satisfies (a) would also satisfy (b) if it were properly structured.
The third test is if the broker, dealer or municipal securities dealer has expressly disclosed in writing to the issuer at or before such termination the source and anticipated amount of all remuneration to the broker, dealer, or municipal securities dealer with respect to such issue in addition to the compensation referred to in Section (c) of this rule and the issuer has expressly acknowledged in writing to the broker, dealer or municipal securities dealer receipt of such disclosure.
In the case of the competitive bidding situation, there is even easier compliance with this rule. In that case, the issuer has expressly consented in writing prior to the bid to such acquisition or participation as follows. Upon advice of the dealer financial adviser, the municipality adopts a resolution approving the sale notice terms. A sentence in that resolution providing consent to the dealer to bid on or participate in such acquisition would satisfy compliance with the rule.
Whereas this rule directs its attention to the conflict of interest when a dealer or broker also serves as financial adviser, it blesses this type of relationship when the dealer or broker discloses this fact. This is saying that a fox that howls as it enters the hen house is entitled to all of the chickens it can catch.
For this rule to serve a purpose, it would have to prohibit an underwriting by a firm that first served as financial adviser for an issuer. Many governments recognize this and prohibit it at the state and local levels.
We think this position reflects the approach that enlightened governments are taking all across this country, and it is the approach that the MSRB should take as it continues to lead the municipal industry toward improved practices.
Mr. Swanson is co-chairman of the National Contacts Committee of the National Association of Independent Public Financial Advisors.