Regulators are focusing their attention on municipal securities firms that effect transactions in municipal securities in an amount lower than the minimum denomination of the issue. Several broker-dealers have been fined for their failure to comply with such minimum denominations.
Background
Issuers set minimum denominations for transactions in municipal bonds. The minimum denomination for a municipal bond should be disclosed in the bond offering documents. An issuer may set a high minimum denomination (commonly $100,000) to qualify for exemptions from SEC Rule 15c2-12.
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In some cases, issuers sets high minimum denominations because it recognizes that the risks associated with the bonds may make them unsuitable for those retail investors who would likely purchase them in amounts below the minimum denomination. The minimum denomination helps ensure that broker-dealers sell high-risk bonds only to investors who are capable of making sizeable investments and are better prepared to bear the higher risk. With limited exceptions, a broker-dealer is prohibited from effecting a customer transaction in an amount below the minimum denomination.
MSRB Rule G-15(f)
MSRB Rule G-15(f) prohibits a broker-dealer from effecting a customer transaction in an amount lower than the minimum denomination of the issue unless the transaction qualifies for an exception. The rule contains two exceptions: (1) one for qualifying purchases of securities from a customer, and (2) a second for qualifying sales of securities to a customer.
Exception #1 – Qualifying Purchases from Customers
To qualify for an exception for the purchase of securities from a customer in an amount lower than the minimum denomination, your firm must do all of the following:
- First, your firm must determine that the customer’s position in the issue is already below the minimum denomination and that the customer’s entire position would be liquidated by the transaction. To make this determination, your firm may rely upon customer account information in its possession or upon a written statement from the customer.
- Second, your firm must document its determination and maintain adequate records to demonstrate that the transaction qualified for the exception.
Exception #2 – Qualifying Sales to Customers
To qualify for an exception for the sale of securities to a customer in an amount lower than the minimum denomination, your firm must do all of the following:
- First, your firm must determine that the securities position being sold to the customer is the result of another customer liquidating an entire position below the minimum denomination, as described above in Exception #1. In other words, your firm’s ability to effect a sale to a customer in an amount below the minimum denomination hinges on the existence of another customer liquidating an entire position below the minimum denomination. To make this determination, your firm may rely upon customer account records in its possession or upon a written statement provided by the party from which the securities are purchased.
- Second, your firm must document its determination and maintain adequate records to demonstrate that the transaction qualified for the exception.
- Third, at or before the completion of the transaction, your firm must give or send to the customer purchasing the securities position a written statement informing the customer that the quantity of securities being sold is below the minimum denomination for the issue and that this may adversely affect the liquidity of the position unless the customer has other securities from the issue that can be combined to reach the minimum denomination. This written statement may be included on the customer’s confirmation or may be provided on a document separate from the confirmation.
Recommendations
In light of the regulatory focus on municipal securities transactions in amounts below minimum denominations set by the issuers, we recommend that you and your firm consider taking the following actions:
- Make sure appropriate persons within your firm, including municipal securities principal(s), have received this communication and have assessed the adequacy of your firm’s controls and supervisory procedures for complying with the requirements of Rule G-15(f).
- Make sure your firm’s registered representatives and supervisors are aware of the regulatory focus on municipal securities transactions in amounts below the minimum denomination, and deliver training to them on the requirements of MSRB Rule G-15(f). Also be sure to document all such training as well.
- Establish a regular review process to verify compliance with the requirements of MSRB Rule G-15(f).