FINRA, in an Acceptance, Waiver and Consent (AWC), recently settled an action with NatAlliance Securities for violations of MSRB Rule G-13, G-17 and G-27.

The settlement of a matter involving G-13 is the first time a firm has been charged with violating that rule since 2003 and left some wondering if FINRA was using enforcement cases to establish compliance standards while counsel for NatAlliance stated that FINRA is “going to use this to put people on notice if there is conduct even remotely similar to what they alleged in this AWC.”

The AWC Overview provides that, “NatAlliance engaged in a pattern and practice of distributing or publishing unsupported “throw-away” bids in multiple illiquid municipal securities that were not based on the firm’s best judgment of the fair market value (FMV) of the securities” and that “such conduct [and other conduct cited in the AWC] violated Municipal Securities Rulemaking Board (MSRB) Rules G-13, G-17 and G-27.”

The AWC cited MSRB Rule G-13(b)(ii) and associated interpretive guidance (circa 1988) pointing to the requirement that “… any quotation [be] based on the best judgment of such broker, dealer or municipal securities dealer of the FMV of the securities…” and that “when determining the FMV, the dealer should consider relevant circumstances such as the firm‘s inventory, the value of comparable securities and the anticipated direction of the movement of the market of the securities.” MSRB Notice 2012-34 (June 25, 2012), also cited, provides “the fact that the bid price that wins a bid-wanted or offering may well not represent the true fair market value of the security is evidenced by the trade activity observed by enforcement agencies following such actions.”

Reading the AWC, a few things are important to note. First, the case dealt with illiquid municipal securities. We’re not sure that designation can provide comfort as to the potential limited scope of the settlement. The MSRB’s own data confirms the relative illiquidity of most municipal bonds following the initial 60 days after issuance.

Further, the AWC provides that NatAlliance bid on bonds in response to bid-wanted auctions by broker-dealers and was the only bidder in one instance and the highest bidder in another. They then sold the bonds at a considerable profit a day or more later. The AWC also highlights the bids and transactions between institutional market participants and points to G-17 citing the “general duty to deal fairly with all persons … extends to dealings with all persons, including other dealers…” Several market participants we have spoken with have expressed surprise the AWC cited a violation of G-17 in such circumstances.

One has to question whether this action by FINRA represents a fundamental shift in how regulators wish to influence what is permissible with respect to trading profits between sophisticated counterparties. Further, it raises concerns regarding how regulation may impact the liquidity of securities and constrains the market’s ability to freely discover market clearing levels for securities.

Irrespective of what one may think, NatAlliance, which had no relevant disciplinary history and was ably represented by nationally recognized counsel, settled. In other words, FINRA took this seriously and, as counsel for NatAlliance noted, “I think [FINRA] is going to use this to put people on notice.”

As you consider mitigants and supervisory procedures, the use of a service that can efficiently identify comparable bonds and trades based on the structural and credit characteristics of the target bond (the bond bid on) is seemingly in order. Lumesis’ Secondary Market Pricing tool and associated solutions provide relevant, real-time data as to trading levels, relevant metrics and complete transparency to all trades so that you can support bids.

Anything short of demonstrating the same may serve as the basis for a G-13, G-17 and G-27 enforcement action.