[Federal Register Volume 59, Number 71 (Wednesday, April 13, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-8839]


[[Page Unknown]]

[Federal Register: April 13, 1994]


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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-33869; File No. SR-MSRB-94-01]

 

Self-Regulatory Organizations; Order Approving Proposed Rule 
Change by the Municipal Securities Rulemaking Board Relating to 
Suitability of Recommendations

April 7, 1994.
    On January 7, 1994, the Municipal Securities Rulemaking Board 
(``Board'' or ``MSRB'') filed with the Securities and Exchange 
Commission (``Commission'' or ``SEC'') pursuant to section 19(b)(1) of 
the Securities Exchange Act of 1934 (``Act''),\1\ a proposed rule 
change consisting of amendments to rule G-19, concerning suitability of 
recommendations, and rule G-8 concerning recordkeeping. The proposed 
rule change was published for comment in the Federal Register.\2\ No 
comments were received. For the reasons discussed below, the Commission 
is approving the proposed rule change.
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    \1\15 U.S.C. 78s(b)(1) (1988).
    \2\Exchange Act Release No. 33498 (January 21, 1994), 59 FR 3891 
(January 27, 1994).
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I. Background

    In a letter dated May 8, 1992, the Commission's Division of Market 
Regulation asked the MSRB to review the requirements of rule G-19 on 
suitability of recommendations and to consider strengthening the 
requirements for transactions in certain types of municipal 
securities.\3\ In September 1992, the Board published a request for 
comments on a number of customer protection issues, including the 
application of rule G-19 to customer transactions.\4\ After reviewing 
these matters, the MSRB decided that rule G-19 embodies the appropriate 
general standard for dealers in making recommendations to customers, 
but recognized that there was a perception that certain provisions of 
the rule could be viewed as permitting recommendations to go forward 
without proper regard to the nature of the security being recommended 
and the customer to whom it is recommended. Accordingly, at its May 
1993 meeting, the Board approved a Request for Comments on draft 
amendments to clarify and strengthen the suitability requirements of 
rule G-19. The MSRB requested public comment on the proposal,\5\ and 
draft amendments were approved at the November 1993 Board meeting and 
form the basis of the rule change proposed herein. Shortly thereafter, 
12 groups and associations representing a broad range of market 
participants submitted to the Commission a Joint Statement on 
Improvements in Municipal Securities Market Disclosure.\6\ The Joint 
Statement called on the MSRB to monitor the effectiveness of its 
suitability rules and to strengthen those rules if appropriate.\7\ The 
Joint Statement specifically called for suitability rules to require 
disclosure of ratings and whether the issuer has committed to provide 
annual financial reports.\8\ In September, 1993, the MSRB indicated it 
was considering requiring municipal securities dealers to disclose to 
their customers the importance of secondary market information and 
whether the issuer has agreed to voluntarily provide such 
disclosures.\9\
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    \3\See Letter from William H. Heyman, Director, Division, 
Commission, to Christopher Taylor, Executive Director, MSRB (May 8, 
1992). See also Remarks of Richard Y. Roberts, Commissioner, SEC, 
``Proposals to Improve the Integrity of the Municipal Securities 
Market,'' Before the Bond Club of Virginia (June 13, 1992); 
``Preserve Integrity of Municipal Securities Market,'' Before the 
1992 Bond Buyer Municipal Finance Conference (October 22, 1992); and 
``Commentary on Customer Protection Study Comments,'' Before the 
Public Securities Association (February 25, 1993).
    \4\MSRB Reports, Vol. 12, No. 3 (Sept. 1992) at 3-7.
    \5\MSRB Reports, Vol. 13, No. 3 (June 1993) at 7-10.
    \6\Joint Statement on Improvements in Municipal Securities 
Market Disclosure (``Joint Statement'') (December 20, 1993). The 
Joint Statement was submitted by the American Bankers Association's 
Corporate Trust Committee, American Public Power Association, 
Association of Local Housing Finance Agencies, Council of 
Infrastructure Financing Authorities, Government Finance Officers 
Association, National Association of Bond Lawyers, National 
Association of Counties, National Association of State Auditors, 
Comptrollers and Treasurers, National Association of State 
Treasurers, National Council of State Housing Agencies, National 
Federation of Municipal Analysts, and Public Securities Association.
    \7\Id. at 3.
    \8\Id. at 4.
    \9\See MSRB, Report of the Municipal Securities Rulemaking Board 
on Regulation of the Municipal Securities Market (Sept. 1993) at 6-
7.
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II. Description

    The proposed rule change amends MSRB rules G-19 and G-8 and is 
designed to strengthen the Board's customer suitability rule.
    It eliminates two provisions from rule G-19. Rule G-19 generally 
requires that before making any recommendations to a customer, a dealer 
must first determine that the proposed transaction is suitable for the 
customer. One provision of the rule in its current form, which is in 
effect an exemption to it, permits a dealer to make a recommendation 
when a customer fails to provide sufficient information about himself, 
as long as the dealer has no reasonable grounds to believe and does not 
believe that the recommendation is unsuitable. The Board proposes 
deleting the provision to avoid any ambiguities regarding a dealer's 
obligation to make a suitability determination and to prevent any 
future use of the provision as an excuse for unsuitable 
recommendations. As a result of this rule change, a dealer who lacks 
specific information regarding a customer's financial status or 
investment objective, but reasonably believes that an investment is 
suitable for the customer, would not be permitted to go forward with 
the recommendation.
    A second exemptive provision of the current rule allows dealers to 
recommend specific municipal securities to investors who want to invest 
in those securities even after being informed by the dealer that, based 
on their financial circumstances, investments in those securities would 
not be suitable. The Board also proposes deleting this provision to 
strengthen the suitability rule.
    The proposed rule change also amends rule G-19 to clarify the 
information that municipal securities dealers must obtain from 
customers and when it must be obtained. For non-institutional 
customers, the rule change clarifies that dealers must make reasonable 
efforts to obtain the following information: The customer's financial 
status, tax status, investment objectives and such other information 
used or considered to be reasonable and necessary by the dealer in 
making recommendations to the customer.\10\ The proposal does not 
establish a specific list of items that must be requested from 
institutional accounts.
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    \10\The proposed rule change also clarifies rule G-8 to require 
that customer suitability information used to make a suitability 
determination be recorded in the customer account record.
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    The suitability rule itself applies equally to institutional and 
non-institutional accounts, irrespective of the different information 
gathering requirements. It states that for each recommendation of a 
municipal securities transaction, a broker or dealer shall have 
reasonable grounds, based upon information available from the issuer 
and facts disclosed by the customer or otherwise known about the 
customer, to believe that the recommendation is suitable.
    The proposed rule change also revises the definition of 
``institutional account'' contained in rule G-8. The new definition 
would add the accounts of savings and loan associations, investment 
advisers registered under Section 203 of the Investment Advisers Act of 
1940 and other entities (whether a natural person, corporation, 
partnership, trust, or otherwise) with total assets of at least $50 
million to those of banks and registered investment companies under the 
definition of ``institutional accounts.'' This amendment would make the 
Board's definition of ``institutional account'' the same as that 
established by Article III, section 21(c)(4) of the National 
Association of Securities Dealers (``NASD'') Rules of Fair Practice for 
purposes of suitability determinations.

III. Discussion

    Since the adoption of suitability rules in the late 1970's, there 
have been significant changes in the municipal securities markets. The 
number of retail investors has increased and the introduction of more 
complex, and in some cases, speculative municipal securities has become 
a characteristic of today's market. In addition, there have been a 
number of defaults in municipal securities in recent years, including 
some defaults in unrated and conduit bonds.\11\
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    \11\Examples include the defaults engendered by the failures of 
Tucson Electric Power and Washington (State) Public Power Supply 
System, and the bankruptcies arising out of the Colorado Special 
Districts. See, e.g., Stamas, ``Rep. Dingell Asks SEC to Investigate 
Defaults by Special Assessment Districts in Colorado,'' The Bond 
Buyer at 1 (Jan. 25, 1991); Doyle, ``SEC Chief Tells Congress Muni 
Market Probe Still Underway,'' Associated Press (September 9, 1993).
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    As a result of these developments, the Commission believes it is 
critical that dealers have clear policies to ensure that sales 
personnel do not recommend securities to customers without proper 
regard to the nature of the security being recommended and the customer 
to whom it is being recommended. Furthermore, because of the lack of 
available information regarding prices and risk of municipal 
securities, brokers and dealers have an information advantage relative 
to their customers. Particularly in such an environment, it is wholly 
appropriate to hold brokers and dealers to high professional standards 
when making recommendations to their customers.\12\
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    \12\As part of its overall effort to improve customer protection 
in the municipal securities market, the Commission also recently 
published for comment a proposed amendment to Rule 15c2-12 under the 
Securities Exchange Act of 1934. This amendment would, inter alia, 
make it unlawful for a broker or dealer to recommend the purchase or 
sale of a municipal security, without having reviewed the 
information the issuer of the municipal security has undertaken to 
provide. The purpose of the proposed amendment is to further deter 
fraud and manipulation in the municipal securities market by 
prohibiting the underwriting and subsequent recommendation of 
securities for which adequate information is not available.
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    The Commission believes that the proposed rule change is consistent 
with the Act and the rules and regulations thereunder applicable to the 
Board and in particular, section 15B(b)(2)(C), which authorizes the 
Board to adopt rules designed to prevent fraudulent and manipulative 
acts and practices, to promote just and equitable principles of trade, 
to foster cooperation and coordination with persons engaged in 
facilitating transactions in municipal securities and, in general, to 
protect investors and the public interest.
    The Commission notes also that the proposed rule change addresses 
the concerns raised by the Division of Market Regulation in its 1993 
report to Congress on the Municipal Securities Market.\13\ In that 
report, the Division cited sales practices as one area that could 
benefit from increased MSRB attention and specifically encouraged the 
MSRB to update its suitability and customer protection rules.
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    \13\Division of Market Regulation, Securities and Exchange 
Commission, Staff Report on the Municipal Securities Market (Sept. 
1993).
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    The Commission believes that the proposed rule change will help 
prevent fraudulent and deceptive practices and promote just and 
equitable principles of trade because it is designed to ensure that 
dealers, before making a recommendation to a customer, take appropriate 
steps to determine that the municipal securities transaction is 
suitable. In particular, by clarifying and strengthening the rules 
governing the inquiries dealers must make of customers and the 
circumstances under which recommendations are permissible, the rule 
change will further important goals such as assuring the integrity of 
the market for municipal securities and safeguarding the interests of 
the investing public.
    Institutional customers also will be better protected under the 
proposed rule change because brokers an dealers will be required to 
have reasonable grounds, based upon information available from the 
issuer and facts disclosed by or known about a customer, for believing 
that a recommendation is suitable, whether or not the client is an 
institution. Institutional and non-institutional customers will be 
treated differently only with respect to the precise information that 
must be obtained prior to a recommendation. For both types of 
customers, information still must be obtained that is adequate to 
support a reasonable suitability determination. There will be no 
difference in the standard a broker or dealer is held to in determining 
the suitability of that recommendation. Thus, in many cases, even 
though not required to obtain certain types of customer information for 
recordkeeping purposes, dealers will, as a practical matter, need to 
obtain the same types of information for certain institutional accounts 
as would be required for non-institutional accounts.\14\
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    \14\The Commission believes that the NASD and the MSRB should 
reconsider specifying information collection requirements for 
dealers when recommending securities to ``institutional accounts.'' 
In particular, the Commission believes that the NASD and the MSRB 
should evaluate (i) the appropriateness of dealers making such 
recommendations to high net worth individuals, absent the kind of 
information required to be obtained for non-institutional accounts; 
and (ii) the need to provide dealers with more definite guidance 
regarding the kind of customer information that they should obtain 
before making recommendations to different types of institutional 
accounts.
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    Furthermore, by revising the definition of ``institution'' to 
conform with the definition used by the NASD,\15\ the proposed rule 
change promotes consistency in classification, thereby facilitating the 
determination of the proper duty of inquiry owed to the particular 
client, and reduces confusion in the administration, compliance and 
surveillance of municipal securities dealers by NASD examiners.
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    \15\NASD Rules of Fair Practice, Art. III, section 2(b), NASD 
Manual (CCH) 2152.
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    It is therefore ordered, Pursuant to section 19(b)(2) of the Act, 
that the proposed rule change be, and hereby is, approved.

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-8839 Filed 4-12-94; 8:45 am]
BILLING CODE 8010-01-M