LIBOR Transition: (Bet You Didn't Know) Municipal Advisors’ and Underwriters’ Duties

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General

The discontinuation of LIBOR may impact the activities and obligations of municipal advisors by presenting a material risk for certain market participants including municipal issuers and obligated persons (i.e. conduit borrowers). Municipal advisors provide advice to municipal issuers or conduit borrowers concerning municipal financial products or municipal securities.[2] If such products or securities are linked to LIBOR and continue past LIBOR’s expected termination date, then the LIBOR transition is particularly relevant to the advice rendered by municipal advisors.

It should be noted that the SEC’s Division of Examinations is examining whether municipal advisors have met their fiduciary duty obligations to municipal entity clients, including the disclosing of, and managing of, conflicts of interest and documentation within the scope of their client engagements.[3]

Duties of Municipal Advisors

The standard of conduct governing a municipal advisor’s obligations throughout the LIBOR transition depends on whether the municipal advisor is a solicitor or a non-solicitor advisor.[4] Non-solicitor advisors, what an issuer and a conduit borrower will typically consider a ‘Municipal Advisor”, are subject to MSRB Rules G-42 and G-17. Solicitor advisors are currently only subject to MSRB Rule G-17, although proposed MSRB Rule G-46 would impose additional obligations if enacted.

Non-Solicitor Municipal Advisors (MSRB Rule G-42)

Municipal Securities Rulemaking Board (MSRB) Rule G-42 sets forth the duties of non-solicitor municipal advisors. The rule describes, in a simple fashion, the core elements of such duties, while the supplementary materials to the rule notes that more restrictive requirements could be placed by state or other laws.[5]

Fiduciary Duties

MSRB Rule G-42 imposes fiduciary duties on non-solicitor municipal advisors when dealing with municipal issuers, including both (i) a duty of care and (ii) a duty of loyalty. In contrast, when dealing with conduit borrowers, a municipal advisor is only subject to a duty of care.[6] Municipal advisors also advise issuers in the sale of bonds and are subject to a fiduciary duty in such transactions as well.[7]

Duty of Care

The duty of care requires municipal advisors to possess the requisite knowledge and expertise to render informed advice. Municipal advisors must also make reasonable inquiries into facts that form the basis for their advice or that are relevant to a client’s decision-making. Further, municipal advisors are required to undertake reasonable investigations to ensure that recommendations are not based on materially inaccurate or incomplete information, and must have a reasonable basis for any advice provided to or on behalf of a client.[8]

Duty of Loyalty

The duty of loyalty, which is only applicable to municipal issuer clients, requires municipal advisors to deal honestly and in good faith, acting only in the best interests of the client without regard of the interests of the municipal advisor. This obligation is similar to MSRB Rule G-17, which imposes a fair dealing standard and applies to both solicitor and non-solicitor municipal advisors.[9] Additionally, the duty of loyalty prevents a municipal advisor from engaging in municipal advisory activities if it cannot manage or mitigate conflicts of interest in a manner that will allow it to act in the client’s best interests.[10]

Conflicts of Interest Disclosure

MSRB Rule G-42 places several other obligations on municipal advisors. First, municipal advisors must disclose conflicts of interest to municipal issuer or conduit borrower clients. These disclosures must be sufficiently detailed, in order to inform the client of the nature, implications and potential consequences of the conflict.[11]

Suitability

Municipal advisors are also required to have a reasonable basis to believe that recommendations are suitable for a client. To reach this recommendation, municipal advisors should consider various factors including a client’s tax status, risk tolerance and liquidity needs.[12] In connection with this suitability requirement, a municipal advisor must inform clients of its evaluation of the risks, benefits and structure of the transaction or financial product, the basis for its suitability determination, and whether it considered reasonably feasible alternatives.[13]

Finally, a municipal advisor is required to know and retain the essential facts concerning a client, which may include the facts necessary to effectively serve the client, to act according to special directions, to understand the authority of persons acting on behalf of the client, and to comply with applicable laws, regulations and rules.[14]

Solicitor Municipal Advisors (Proposed MSRB Rule G-46)

In addition to MSRB Rule G-17’s fair dealing requirement, solicitor municipal advisors’ duties are further clarified in the MSRB Rule G-17 Excerpt for Solicitor Municipal Advisors (the “G-17 Excerpt”). This excerpt reminds solicitor municipal advisors that they must not misrepresent or omit facts and are obligated to disclose all material facts about the solicitation, including information about compensation.[15] The excerpt also notes that solicitor municipal advisors, unlike non-solicitor municipal advisors, do not owe a fiduciary duty to municipal issuers [or conduit borrowers].

Proposed MSRB Rule G-46 codifies the key principles from the G-17 Excerpt and adds a few additional requirements.[16] Among other new obligations, the proposed rule would require solicitor municipal advisors to document relationships in writing and disclose additional information about the advisor’s role, compensation and conflicts of interest.[17] As it currently stands, proposed MSRB Rule G-46 does not explicitly state the standard of conduct that applies to solicitor municipal advisors, a concern brought up by the Securities Industry and Financial Markets Association (SIFMA) during the Rule’s comment period.[18]

Duties of Underwriters (MSRB Rule G-17)

MSRB Rule G-17’s fair dealing standard also applies to underwriters and requires them to disclose conflicts of interests to issuers of municipal securities. Additionally, underwriters must disclose that:

1. MSRB Rule G-17 requires an underwriter to deal fairly at all times with both municipal issuers and investors;
2. the underwriter’s primary role is to purchase securities with a view to distribution in an arm’s-length commercial transaction with the issuer, and it has financial and other interests that differ from those of the issuer;
3. unlike a municipal advisor, the underwriter does not have a fiduciary duty to the issuer under Federal securities laws and is, therefore, not required by Federal law to act in the best interests of the issuer without regard to its own financial or other interests;
4. the underwriter has a duty to purchase securities from the issuer at a fair and reasonable price, but must balance that duty with its duty to sell municipal securities to investors at prices that are fair and reasonable; and
5. the underwriter will review the official statement [offering document] for the issuer’s securities in accordance with, and as part of, its responsibilities to investors under Federal securities laws, as applied to the facts and circumstances of the transaction.[19]

The August 2012 Interpretive Notice was amended in 2019 to add an additional disclosure that underwriters must make to issuers, but the amendment did not come into effect until early 2021.[20] For all underwriting relationships formed after March 31, 2021, the underwriter must disclose that, “the issuer may choose to engage the services of a municipal advisor with a fiduciary obligation to represent the issuer’s interests in the transaction.”[21]

The revised interpretive notice also makes clear that underwriters may not discourage issuers from hiring a municipal advisor or imply that a municipal advisor’s services are redundant because of the provision by the underwriter of its services.[22]

Transition from LIBOR

The SEC’s Division of Examinations published a Risk Alert warning that the transition from LIBOR may present a material risk to municipal advisors and other market participants including municipal issuers [and conduit borrowers].[23] The SEC will be conducting examinations to assess participants’ preparation for the LIBOR transition, and the Risk Alert discusses five (5) key aspects that participants should consider:[24]

1. The entity’s and investors’ exposure to LIBOR-linked contracts that extend past the current expected discontinuation date, including any fallback language incorporated into these contracts;
2. The entity’s operational readiness, including any enhancements or modifications to systems, controls, processes, and risk or valuation models associated with the transition to a new reference rate or benchmark;
3. The entity’s disclosures, representations, and/or reporting to investors regarding its efforts to address LIBOR discontinuation and the adoption of alternative reference rates;
4. Identifying and addressing any potential conflicts of interest of the underwriter associated with the LIBOR discontinuation and the adoption of alternative reference rates; and
5. Clients’ efforts to replace LIBOR with an appropriate alternative reference rate.[25]

[1] Office of Municipal Securities’ ‘Staff Statement on LIBOR Transition In The Municipal Securities Market’ dated January 8, 2021.

[2] See Securities Exchange Act, 15 U.S.C § 78o-4 (e) (4).

[3] ‘SEC Division of Examinations Announces 2021 Examination Priorities – Focus Areas Involving Broker-Dealers and Municipal Advisors’ dated March 3, 2021. In December 2020, the SEC’s Office of Compliance Inspections and Examinations was renamed the Division of Examinations, omitting the reference to compliance inspections.

[4] The Securities Exchange Act defines a “solicitation of a municipal entity or obligated person” as a communication made by a person, “for direct or indirect compensation, on behalf of a broker, dealer, municipal securities dealer, municipal advisor, or investment adviser . . . that does not control, is not controlled by, or is not under common control with the person undertaking such solicitation for the purpose of obtaining or retaining an engagement . . . .”  (e) (9).

[5] See ‘SEC Approves New MSRB Rule G-42 on Duties of Non-Solicitor Municipal Advisors and Related Amendments to MSRB Rule G-8’ issued in 2016 by MSRB.

[6] See MSRB Rule G-42 (a) (i)-(ii).

[7] Government Finance Officers Association (GFOA) ‘Best Practices: Selecting and Managing Municipal Advisors’ dated February 28, 2014.

[8] See MSRB Rule G-42, Supplementary Material (SM) .01.

[9] MSRB Rule G-17 states, “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” (emphasis added). All persons include municipal issuers and conduit borrowers.

[10] See id. SM .02.

[11] See id. SM .05.

[12] See id. SM .09.

[13] See MSRB Rule G-42 (d) (i)-(iii).

[14] See SM .10.

[15] See ‘Application of MSRB Rules to Solicitor Municipal Advisors’ dated May 4, 2017.

[16] See ‘Request for Comment on Fair Dealing Solicitor Municipal Advisor Obligations and New Draft Rule G-46’ dated March 17, 2021.

[17] See id.

[18] Letter from Leslie M. Norwood, Managing Dir. and Assoc. Gen. Counsel, SIFMA, to Ronald W. Smith, Corporate Sec’y, MSRB (June 17, 2021). The comment period for proposed MSRB Rule G-46 ended June 17, 2021.

[19] ‘Interpretive Notice Concerning the Application of MSRB Rule G-17 to Underwriters of Municipal Securities’ dated August 2, 2012 (the “August 2012 Interpretive Notice”).

[20] See ‘SEC Approves Amendments to Underwriters’ Fair Dealing Obligations to Issuers Under Rule G-17’ dated November 8, 2019.

[21] ‘MSRB Reminds Dealers of the March 31, 2021 Compliance Date for the Revised Interpretive Notice of Underwriters’ Fair Dealing Obligations to Issuers’ dated February 16, 2021.

[22] See id.

[23] See Divisions of Examinations Risk Alert, ‘Examination Initiative: LIBOR Transition Preparedness’ dated June 18, 2020 (the “Risk Alert”). In July 2020, the SEC created the Event and Emerging Risk Examination Team in the Division of Examinations.

[24] Also see ‘Overlooked Issues for LIBOR Transition: Board Governance and Disclosure Requirements’ dated July 14, 2021.

[25] See the Risk Alert.