Hedge Fund Articles

MSRB Clarifies Obligations Under Investor Protection Rules

On January 22, 2008, the Municipal Securities Rulemaking Board (MSRB) issued a notice to clarify the obligations of broker/dealers and other municipal bond dealers in regard to investor protection rules as applied to transactions in insured municipal securities (the Notice). In summary, those broker/dealers and others who effect transactions in insured municipal bonds need to consider actual and potential rating actions on issuers of bond insurance when making recommendations to anyone other than a “Sophisticated Municipal Bond Professional” as defined in the MSRB’s notice dated April 30, 2002. Of particular interest to hedge fund managers is the guidance MSRB issued concerning the pricing of insured municipal bonds, which arguably applies to all parties who purchase or sell such instruments.

The financial markets have taken, and continue to take, particular notice of the condition of the insurers of municipal bonds. Recent rapid and adverse effects of sub-prime mortgages and other sub-prime financial instruments on the creditworthiness of bond insurers may often not be reflected in market data and bond descriptions provided by market sources to broker/dealers and others. As such, the Notice specifically states that since “rating agency reports” are to be utilized in making suitability determinations concerning insured municipal bonds, independent market information concerning the creditworthiness of bond insurers “may be material information about the transaction.” Broker/dealers and others who deal in insured municipal bonds are instructed to consider both the actual rating actions and any “potential rating actions” that may affect the credit rating and status of the insurers of the municipal bonds they offer and sell. They must consider it not only from a suitability standpoint for the underlying bond itself, but also from a fair pricing standpoint. Arguably, issues of fair pricing have applicability not only to retail investors but sophisticated ones as well, especially those matters where violations of a state uniform securities act provision are alleged.

The Notice states that broker/dealers and municipal bond dealers should: (a) pay increased attention to the facts and circumstances concerning transactions in insured municipal bonds; (b) review past MSRB notices concerning disclosure requirements and other MSRB notices concerning suitability determinations; and (c) review how transactions in insured municipal bonds are being recommended, priced and confirmed.

These new obligations for broker/dealers and municipal bond dealers markedly increase the burden upon market participants to ascertain information concerning the creditworthiness of bond insurers. Notwithstanding one’s sophistication, fund managers should confirm that approved broker/dealers and municipal bond dealers utilized for trading review and revise their written supervisory procedures regarding suitability and pricing determinations to reflect actual and potential credit rating issues, and also determine whether their service providers can assist them in obtaining the information needed to comply with these recent directives from the MSRB. For example, those who utilize prime brokers should verify whether their service providers are taking steps to ensure that trade confirmations and statements contain the appropriate disclosures concerning the timeliness and accuracy of credit ratings. Finally, traders who rely on “bid sheets” and other descriptions of insured municipal bonds from others may wish to take steps to independently determine the accuracy and timeliness of their data.

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