Self-Regulatory Organizations; Municipal Securities Rulemaking Board; Order Granting Approval of Proposed Rule Change and Notice of Filing and Order Granting Accelerated Approval of Amendment No. 1 Relating to Interpretation of Rule G-38 on Consultants Concerning Bank Affiliates and the Definition of Payment

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-40014; File No. SR-MSRB-98-1]

Self-Regulatory Organizations; Municipal Securities Rulemaking

Board; Order Granting Approval of Proposed Rule Change and Notice of

Filing and Order Granting Accelerated Approval of Amendment No. 1

Relating to Interpretation of Rule G-38 on Consultants Concerning Bank

Affiliates and the Definition of Payment

May 20, 1998.

I. Introduction

On January 12, 1998,\1\ the Municipal Securities Rulemaking Board

(``Board''

[[Page 29283]]

or ``MSRB'') submitted to the Securities and Exchange Commission

(``Commission'' or ``SEC''), pursuant to Section 19(b)(1) of the

Securities Exchange Act of 1934 (``Act'') \2\ and Rule 19b-4

thereunder,\3\ a proposed rule change to provide an interpretation of

Rule G-38 on consultants relating to bank affiliates and the definition

of payment. Notice of the proposed rule change appeared in the Federal

Register on January 20, 1998.\4\

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\1\ On November 13, 1997, the Board filed the same proposal as a

Q&A under Section 19(b)(3)(A) of the Act, which rendered the

proposal effective upon receipt of the filing by the Commission. See

Securities Exchange Act Rel. No. 39391 (December 3, 1997), 62 FR

65114 (December 10, 1997) (SR-MSRB-97-8). The Commission received

four comment letters on the filing. See infra note 6. To provide

additional time to fully air the concerns raised by the commenters,

the Board agreed to withdraw this filing and resubmit it, pursuant

to Section 19(b)(2). See letter from Diane G. Klinke, General

Counsel, Municipal Securities Rulemaking Board, to Katherine A.

England, Assistant Director, Division of Market Regulation, dated

January 9, 1998.

\2\ 15 U.S.C. 78s(b)(1).

\3\ 17 CFR 240.19b-4.

\4\ See Securities Exchange Act Rel. No. 39541 (January 12,

1998), 63 FR 3010.

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The Commission received five comment letters specifically

addressing the proposed rule change.\5\ The Commission, however,

received ten comment letters in total which addressed either the

proposed rule change or the proposed rule change that was withdrawn.\6\

All commenters opposed this interpretation, citing discriminatory

effect against banks and bank-affiliated municipal securities dealers

and focusing on the MSRB's jurisdiction concerning the banking

industry. On March 3, 1998, the Board submitted Amendment No. 1 to the

proposed rule change.\7\ This order approves the proposed rule change.

Also, Amendment No. 1 is approved on an accelerated basis.

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\5\ See letter from Sarah A. Miller, Senior Government Relations

Counsel, Trust and Securities, American Bankers Association, to

Jonathan G. Katz, Secretary, SEC, dated February 10, 1998 (``ABA

Letter No. 2''); letter from Mae A. Cavoli, Senior Vice President,

Senior Managing Counsel, KeyCorp Management Company, to Jonathan G.

Katz, Secretary, SEC, dated February 10, 1998 (``KeyCorp Letter'');

letter from William E. Marquis, Associate Counsel, Mellon Bank

Corporation, to Jonathan G. Katz, Secretary, SEC, dated February 9,

1998 (``Mellon Bank Letter No. 2''); letter from Robert J. Nagy,

Senior Counsel, NationsBank, to Jonathan G. Katz, Secretary, SEC,

dated February 10, 1998 (``NationsBank Letter No. 2''); letter from

Victor M. DiBattista, Chief Regional Counsel, PNC Bank, N.A., dated

February 10, 1998 (``PNC Letter No. 2'').

\6\ These letters were resubmitted; they were originally

submitted to address SR-MSRB-97-8. Letter from Sarah A. Miller,

Senior Government Relations Counsel, Trust and Securities, American

Bankers Association, to Jonathan G. Katz, Secretary, SEC, dated

December 30, 1997 (``ABA Letter No. 1''); letter from Michael E.

Bleier, General Counsel, Mellon Bank Corporation, to Jonathan G.

Katz, Secretary, SEC, dated January 12, 1998 (``Mellon Bank Letter

No. 1''); letter from Robert J. Nagy, Senior Counsel, NationsBank,

to Jonathan G. Katz, Secretary, SEC, dated December 31, 1997

(``NationsBank Letter No. 1''); letter from Victor M. DiBattista,

Chief Regional Counsel, PNC Bank, N.A., to Jonathan G. Katz,

Secretary, SEC, dated January 2, 1998 (``PNC Letter No. 1'').

This letter, which was also initially submitted to address SR-

MSRB-97-8, was not resubmitted. Letter from Alan R. Leach, Senior

Vice President and Manager, Dealer Bank Department, Deposit Guaranty

National Bank, to Jonathan G. Katz, Secretary, SEC, dated January 5,

1998 (``Deposit Guaranty Letter'').

\7\ See infra note 13. The Board's response to the comment

letters also included an amendment to the interpretation. The

amended language clarifies that the consultant may be either the

affiliate itself or an individual employed by the affiliate.

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II. Description of the Proposal

Recently, the Board has received inquiries from market participants

concerning the definition of payment, as used in Rule G-38, and whether

bank affiliates and their employees may, under certain circumstances,

be deemed consultants for purposes of the rule.\8\ Specifically, a bank

and its employees communicate with an issuer on behalf of an affiliated

dealer to obtain municipal securities business. The affiliated dealer

issues credits to identify, for internal purposes, the source of

business referrals; however, these credits do not involve any direct or

indirect cash payments from the dealer to the bank or its employees.

The issue is whether the credits received by a bank and its employees

from an affiliated dealer qualify as ``payment'' under Rule G-38, thus

requiring the dealer to designate the bank or its employees as

consultants and comply with the requirements of Rule G-38.

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\8\ To assist brokers, dealers, and municipal securities dealers

in understanding and complying with its rules, the Board publishes

notices of interpretation, in question-and-answer format, when

warranted. Two sets of Q&A's have previously been published

providing the Board's interpretation of the application of Rule G-

38. See Securities Exchange Act Release No. 36950 (March 11, 1996);

61 FR 10828 (March 15, 1996) and Securities Exchange Act Release No.

37997 (Nov. 29, 1996); 61 FR 64781 (Dec. 6, 1996).

See also MSRB Reports Vol. 16, No. 2 (June 1996) at 3-5; and

Vol. 17, No. 1 (Jan. 1997) at 15.

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Rule G-38 defines a consultant as any person used by a dealer to

obtain or retain municipal securities business through direct or

indirect communication by such person with an issuer on behalf of the

dealer where the communication is undertaken by the person in exchange

for, or with the understanding of receiving, payment from the dealer or

any other person.\9\ The term payment, as used in Rule G-38, means any

gift, subscription, loan, advance, or deposit of money or anything of

value.\10\ Under the Board's interpretation of payment in this proposed

rule change, the absence of an immediate transfer of funds or anything

of value, such as credits, to an affiliate or individual employed by

the affiliate would not exclude the credits from the definition of

payment if such credits eventually (e.g., at the end of the fiscal

year) result in compensation to the affiliate or individual employed by

the affiliate for referring municipal securities business to the

dealer. In this regard, the compensation may be in the form of cash

(e.g., a bonus) or non-cash. In either case, if the dealer or any other

person \11\ eventually gives anything of value (i.e., makes a

``payment'') to the affiliate or individual, based even in part on the

referral, then the affiliate or individual is a consultant for purposes

of Rule G-38 and the dealer must comply with the various requirements

of the rule.

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\9\ Municipal finance professionals and any person whose sole

basis of compensation is the actual provision of legal, accounting

or engineering advice, services or assistance are exempted from the

definition of consultant.

\10\ MSRB Manual, General Rules, Rule G-38(a)(v) (CCH) para.

3686.

\11\ The Act defines the term ``person'' as a ``natural person,

company, government, or political subdivision, agency, or

instrumentality of a government.'' Board Rule D-1 provides that

unless the context otherwise specifically requires, the terms used

in Board rules shall have the same meanings as set forth in the Act.

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III. Summary of Comments

All of the comment letters addressing the proposed rule change

opposed the proposed rule change, raising several issues.\12\ At the

Commission's request, the Board submitted a response which addresses

these issues.\13\

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\12\ See supra notes 5 and 6.

\13\ See letter from Diane G. Klinke, General Counsel, MSRB, to

Katherine A. England, Esq., Assistant Director, Division of Market

Regulation, SEC, dated March 2, 1998 (``MSRB Letter'' and

``Amendment No. 1'').

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Most commenters contend that the Board's interpretation is an

impermissible extension of rule G-38 to banks' soft dollar compensation

programs.\14\ These commenters are concerned that this interpretation

would infringe upon the most effective method used by financial

institutions to cross-sell their various products and services to a

wide range of customers.\15\ According to the MSRB, this interpretation

merely clarifies what is already required and is reasonably and fairly

implied by the rule; it does not reflect a change in MSRB policy.\16\

The rule requires disclosure of the ``compensation arrangement'' of any

consultant used by a dealer to obtain or

[[Page 29284]]

retain municipal securities business.\17\ The Board is aware that

consultants are sometimes paid in non-cash compensation, and thus

specifically chose the term ``compensation arrangement'' because it did

not want to limit the disclosure to cash payments.\18\ Thus, the

interpretation is not an unwarranted extension to soft dollar

compensation arrangements, because the rule already applied to such

arrangements.\19\ The Commission agrees with the MSRB'S explanation

that the dealer's disclosure requirements are specifically delineated

in the rule, and that the interpretation is consonant with these

requirements.

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\14\ ABA Letter No. 2, p. 1, Deposit Guaranty Letter, p. 2,

Nationsbank Letter No. 2, p. 2, Mellon Bank Letter, p. 2, and PNC

Letter No. 2, p. 2.

\15\ Id.

\16\ MSRB Letter, p. 2.

\17\ MSRB Manual, General Rules, Rule G-38(c) (CCH) para.3686.

\18\ MSRB Letter, p. 2.

\19\ Id.

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The commenters also suggest that the interpretation is unworkable

when applied to non-traditional compensation programs, given the

subjective nature of the calculations, and would significantly

discourage traditional banking referral programs.\20\ According to

these commenters, most compensation programs are based on factors other

than the initial credit allocation. Thus, translating credits allocated

by the affiliated dealer into a specific dollar amount of the

employees' compensation would be difficult because the reports are due

quarterly; referral compensation, however, is usually awarded in the

form of a year end bonus.\21\ The MSRB notes that Rule G-38 requires,

among other things, that each broker, dealer, and municipal securities

dealer disclose to the Board certain information relating to each

consultant used by the dealer during the reporting period to obtain or

retain municipal securities business.\22\ This definition also includes

bank dealers.\23\ Furthermore, the Board notes that based on a review

of reports submitted, several bank dealers and bank-affiliated dealers

have been disclosing the information required by Rule G-38.\24\ These

dealers have listed as consultants their bank affiliates and bank

employees, and have disclosed the compensation arrangements for such

consultants (either in dollar or as a formula), as well as dollar

amounts paid to consultants.\25\

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\20\ ABA Letter pp. 2-3, Deposit Guaranty Letter, p. 2,

Nationsbank Letter No. 2, p. 2, Mellon Bank Letter No. 2, pp. 3-4

and PNC Letter No. 2, p. 1.

\21\ Id.

\22\ MSRB Letter, p. 2.

\23\ Id. See also 15 U.S.C. 78c(a)(30) (defining the term

``municipal securities dealer'' pursuant to the Act).

\24\ MSRB Letter, p. 3.

\25\ See, e.g., reports submitted by Sun Trust Bank, Atlanta (3Q

1997); SunTrust Capital Markets, Inc. (3Q 1997); and Norwest

Investment Services, Inc. (2Q and 3Q `997) and available for public

inspection at the Board's Public Access Facility in Alexandria,

Virginia and on the Board's web site at www,msrb.org.

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The commenters contend that rule G-38 should not apply to banks'

referral programs because the intent of the rule is to capture

traditional cash payments made by municipal dealers to independent

consultants (i.e., professionals in the municipal securities arena)

whose primary activity is to obtain or retain municipal securities

business for the dealer.\26\ Moreover, they contend that, as the

employee receives no ``payment'' or ``anything of value'' from the

dealer, but rather from the financial institution itself, the employee

cannot be deemed a consultant for purposes of the rule.\27\ The MSRB

states that these assertions are erroneous. Under Rule G-38, a

consultant is defined as any person used by the dealer to obtain or

retain municipal securities business through direct or indirect

communication with an issuer on the dealer's behalf where the

communication is undertaken by such person in exchange for, or with the

understanding of receiving, payment from the dealer or any other

person.\28\ (emphasis added) The Board drafted the rule language in

this manner to ensure that dealers could not circumvent the rule's

disclosure requirements by claiming that another party compensated a

consultant that referred municipal securities business to the

dealer.\29\ Furthermore, such compensation is not limited to cash

payments; the term ``payment'' is defined as any gift, subscription,

loan, advance, or deposit of money or anything of value.\30\

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\26\ ABA Letter No. 2, pp. 3-5, KeyCorp Letter, Deposit Guaranty

Letter, p. 1, NationsBank Letter No. 2, pp. 1-2, Mellon Bank Letter

No. 2, p. 1, and PNC Letter No. 2, pp. 1-2.

\27\ Id.

\28\ MSRB Letter, p. 3. See supra note 11 for the definition of

the term ``person.''

\29\ MSRB Letter, p. 3.

\30\ Rule G-38(a)(v) states that the term ``payment'' has the

same meaning as in Rule G-37(g)(viii).

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The Commission agrees with the MSRB's assessment. While these

``credits'' may not be initially transmitted in monetary form, they are

a factor in the calculations made to determine eventual monetary

compensation, which is something of value. Moreover, a previous

interpretation published by the MSRB directly addresses this issue.\31\

The MSRB has addressed Q&A No. 7, but Q&A No. 6 is also on point. If an

employee of an affiliated company of a bank introduces one of its

customers (i.e. a municipal issuer) to the bank's dealer department for

purposes of engaging in municipal securities business, and that dealer

pays the affiliated company for this activity, then that employee is

considered a ``finder.'' Any person used by a dealer as a ``finder''

for municipal securities business would be considered a consultant

under Rule G-38.

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\31\ See Securities Exchange Act Release No. 36950 (March 11,

1996), 61 FR 10828 (March 15, 1996) (Q&A No.'s 6 and 7).

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Several commenters stated that the MSRB's proposal unfairly

discriminates against bank-affiliated dealers, because it does not

apply equally to incentive programs established and operated by

financial service firms not affiliated with a bank.\32\ These

commenters also contend that the MSRB's interpretation is an

impermissible extension of its authority into an area exclusively

reserved for bank regulators.\33\ Moreover, because the MSRB lacks

jurisdiction over bank's compensation programs, banks would have to

consent to their municipal securities dealer affiliates filing

proprietary information with the MSRB, an unlikely occurrence, given

the public availability of this information once submitted.\34\

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\32\ ABA Letter No. 2, pp. 3-4, Deposit Guaranty Letter, p. 2,

Mellon Bank Letter No. 2, p. 2, and PNC Letter, pp. 1-2.

\33\ Id.

\34\ Id.

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In its response, the MSRB notes that bank dealers, like securities

firms, are subject to federal securities laws.\35\ Further, all Board

rules apply equally to bank dealers and securities firms. Prior Rule G-

38 interpretations clearly state that the rule applies to both dealer

affiliates and bank affiliates.\36\ If a securities firm has an

affiliate that refers municipal securities business to the dealer in

exchange for ``credits,'' then the affiliate would be a consultant and

the dealer must make the required disclosures under Rule G-38,

including the consultant's compensation arrangement, even if the

payment would be made by ``any other person'' and not by the

dealer.\37\ The Board disagrees with the argument that the proposal

unfairly discriminates against bank-affiliated dealers.\3\8 In fact, if

bank dealers were allowed an exemption from Rule G-38 for referrals by

bank affiliates and their employees, the rule would unfairly

discriminate against non-bank affiliated dealers.\39\ The Commission

agrees that the rule and its disclosure requirements apply equally to

both dealer affiliates and bank

[[Page 29285]]

affiliates. As the MSRB explains, this proposal would also apply if the

circumstance involved a securities firms and its affiliate. The

Commission, therefore, supports the MSRB's assessment, as the

interpretation ensures an evenhanded application of the rule.

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\35\ See supra note 23.

\36\ See supra note 31.

\37\ MSRB Letter, p. 4.

\38\ Id.

\39\ Id.

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In its letters, NationsBank suggests that the MSRB modify the

proposal to clarify that a bank and its employees would only be

consultants under circumstances where the bank receives credits for the

referral of municipal securities business which are then allocated to

employees based on a formulaic fashion.\40\ The MSRB disagrees with

this interpretation and has, therefore, declined to adopt it.\41\

Alternatively, PNC Bank suggests that Rule G-38 be clarified to

designate only the financial institution as the consultant in the case

of soft dollar compensation programs.\42\ In response, the MSRB has

amended Rule G-38 \43\ to say that the consultant may be either the

affiliate or an individual employee of the affiliate.\44\ The dealer

must make this determination and ensure proper compliance with the

rule, including the contractual arrangements and requisite

disclosures.\45\ Thus, the Board has amended the language of the

interpretation to clarify that the consultant may be either the

affiliate itself or an individual employed by the affiliate.\46\

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\40\ NationsBank Letter No. 1 and NationsBank Letter No. 2, p. 2

and its attached modified interpretation.

\41\ MSRB Letter, p. 4.

\42\ PNC Letter No. 2, p. 3.

\43\ See supra notes 8 and 13.

\44\ MSRB Letter, p. 4 and Amendment No. 1.

\45\ Id.

\46\ Id.

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According to the MSRB, Amendment No. 1 clarifies who is deemed a

consultant and the process of designation. The Commission agrees that

the onus should be on the dealer to designate the consultant, whether

affiliate or employee, and to ensure compliance with the rule. The

Commission notes, however, that as amended, the dealer may designate

either the bank affiliate or the employee as the consultant. As noted

in their comments, most banks are reluctant to disclose what they deem

to be proprietary information to the MSRB, and hence, the public.\47\

The Commission notes that both the employee and the affiliate benefit

from referrals facilitated by these soft dollar compensation programs.

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\47\ However, several banks are currently complying with Rule G-

38. See supra note 25.

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IV. Discussion

The Commission believes the proposed rule change is consistent with

the Act and the rules and regulations promulgated thereunder.\48\

Specifically, the Commission believes that approval of the proposed

rule change is consistent with Section 15B(b)(2)(C) \49\ of the Act.

This interpretation clarifies the rule's applicability to all broker-

dealers engaged in the municipal securities business. The

interpretation is necessary to ensure that all persons hired by dealers

to solicit municipal securities business will be covered by the rule.

This interpretation will require that all consultant activity stemming

from attendant soft dollar compensation arrangements, whether those of

financial institutions or securities firms, be disclosed. The

clarification of Rule G-38 regarding referrals by bank affiliates and

their employees will improve the effectiveness of the rule by making

explicit that it applies to all consultants and their political

contribution activity.

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\48\ The Commission has considered the proposed rule's impact on

efficiency, competition and capital formation. The proposed rule

change will add to the information available in the municipal

securities market, and thus, competition, in the municipal

securities markets because all municipal securities dealers will be

required to disclose affiliations and compensation arrangements

concerning their relationships with consultants. Efficiency and

capital formation will be tangentially improved as enhanced

disclosure will likely conserve both capital and personnel

resources. 15 U.S.C. 78c(f).

\49\ Section 15B(b)(2)(C) requires the Commission to determine

that the Board's rules are 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 regulating, clearing, settling, processing

information with respect to, and facilitating transactions in

municipal securities, to remove impediments to and perfect the

mechanism of a free and open market in municipal securities, and, in

general, to protect investors and the public interest.

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The Commission finds good cause for approving proposed Amendment

No. 1 prior to the thirtieth day after the date of publication of

notice of filing thereof in the Federal Register. Amendment No. 1

clarifies who is deemed a consultant and the process of designation.

The Commission agrees that the onus should be on the dealer to

designate the consultant, whether bank affiliate or employee thereof,

and to ensure compliance with the rule, including contractual

arrangements and required disclosures. The dealer's payment of credits

to the consultant creates a strong incentive for the consultant to

solicit an issuer and refer their business to the dealer. The dealer,

therefore, should have the responsibility of documenting its

relationship with the consultant and any compensation arrangements that

result from or facilitate this relationship. For these reasons, the

Commission finds good cause for accelerating approval of the proposed

rule change, as amended.

Interested persons are invited to submit written data, views, and

arguments concerning Amendment No. 1, including whether the amendment

is consistent with the Act. Persons making written submissions should

file six copies thereof with the Secretary, Securities and Exchange

Commission, 450 Fifth Street, N.W., Washington, D.C. 20549. Copies of

the submission, all subsequent amendments, all written statements with

respect to the proposed rule change that are filed with the Commission,

and all written communications relating to the proposed rule change

between the Commission and any person, other than those that may be

withheld from the public in accordance with the provisions of 5 U.S.C.

552, will be available for inspection and copying in the Commission's

Public Reference Room. Copies of the filing will also be available for

inspection and copying at the Board's principal offices. Any

submissions should refer to File No. SR-MSRB-98-1 and should be

submitted by June 18, 1998.

V. Conclusion

For the above reasons, the Commission believes that the proposed

rule change is consistent with the provisions of the Act, and in

particular with Section 15B(b)(2)(C).

It is therefore ordered, pursuant to Section 19(b)(2) of the

Act,\50\ that the proposed rule change (SR-MSRB-98-1), be hereby

approved including Amendment No. 1, on an accelerated basis.

\50\ 15 U.S.C. 78s(b)(2).

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For the Commission, by the Division of Market Regulation,

pursuant to delegated authority.\51\

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\51\ 17 CFR 200.30-3(a)(12).

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Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 98-14119 Filed 5-27-98; 8:45 am]

BILLING CODE 8010-01-M