On November 3, 2014, the SEC announced settlements with thirteen different registered municipal securities dealers in connection with sales of non-investment grade bonds issued by Puerto Rico in 2014.

The settlements were based on alleged violations of Section 15B(c)(1) of the Exchange Act, which prohibits a broker, dealer, or municipal securities dealer from inducing or attempting to induce the sale of any municipal security in contravention of any rule of the Municipal Securities Rulemaking Board.  MSRB Rule G-15(f)(i), in turn, prohibits any municipal securities dealer from effecting a customer transaction in municipal securities in an amount lower than the minimum denomination (except in two specifically identified circumstances).  The thirteen settled actions alleged various sales by the respondent firms that violated this rule.

Here are three observations from these settlements:

1.      Virtual Strict Liability and the “Broken Windows” Approach.  Many of the sales at issue in the thirteen settlements were isolated and unsolicited.  In other of these sales, the firms made full disclosures to the purchasers of the risks associated with the non-investment grade bonds.  And, in most instances, the firms cancelled the sales once the SEC’s Enforcement Division notified them of the potential violation.  In other words, it does not appear as if any firm acted fraudulently in any way, and it does not appear as if investors were harmed.  But none of this changed the fact that the firms all were required to pay a civil penalty in settling the charges.  This underscores a couple of points.  First is the fact that violating MSRB Rule G-15(f)(i) results in near-strict liability.  Second, these settlements are yet one more example (another one is explained here) of the SEC’s “broken windows” approach where minor violations are policed closely to – in theory – prevent or dissuade more serious violations.

2.      Municipal Dealers Need Appropriate Policies.  A few of the settling firms did not have any policies or procedures in place to ensure compliance with MSRB Rule G-15(f)(i).  Having rules in place to ensure compliance with the MSRB Rules, among other things, is crucial and firms should review their rules and procedures to ensure that they are adequate.  Also on this topic, it appears that many of the firms did have appropriate policies in place, but the below-denomination sales still somehow managed to circumvent these policies.  So having a policy is important, but in some respects it is just as important to make sure existing policies are enforced and followed.   

3.      Implications for These Sales Possibly Exist Under Section 5 of the Securities Act.  While the SEC settlements focused on alleged violations of MSRB Rule G-15(f)(i), the below-denomination sales could also constitute a potential violation of Section 5 of the Securities Act, which prohibits sales of unregistered securities.  This is because selling a security in a denomination that has not been authorized by the municipal issuer arguably creates a separate new security that, unlike the original municipal security, is not exempt from registration.