July 01, 2019

Compliance Risks for A/E firms in the Municipal Advisory Business

Joseph Dennis

When we hear “Dodd-Frank,” most think of Wall Street and big banks, but that expansive regulatory regime directly impacts A/E firms providing services that can be construed as involving municipal financial advice.  That regulatory scheme involves professional training and testing requirements as well as criminal penalties and fines for violations.

Prior to  passage of Dodd-Frank in 2010, there was no direct federal regulation governing the financial advisory services provided by A/E firms to a municipality on typical PPP infrastructure projects, such as highways, tunnels, bridges, rail systems and stations.  The complex financial advisory services needed to structure the public financing of these P3 projects were provided by A/E firms and financial services firms who were not required to be federally licensed or registered. Under Dodd-Frank, now such advice is a regulated activity and includes a registration requirement with the Securities Exchange Commission (SEC) for municipal advisor firms, including A/E firms, that meet the Law’s definitions of “Municipal Advisor,” and are not subject to one of the Law’s exceptions.  SEC granted regulatory oversight power to the Municipal Securities Rulemaking Board (MSRB).

What is a “Municipal Advisor”?

A “Municipal Advisor” is defined, in part, as “[a] person or entity (with certain exceptions) that (a) provides advice to or on behalf of a municipal entity . . . municipal financial products or the issuance of municipal securities, or (b) solicits a municipal entity, for compensation . . . .”  One of the critical “exceptions” noted in the definition is the “Engineering Exclusion.”  The name of that exception may give false comfort because it is the nature of the services being provided that earns the exception, and not the title of the service provider.

The Engineering Exclusion

It is only “to the extent that the engineer is providing engineering advice” that the engineer is excluded from the definition of Municipal Advisor.  To have the haven of the Engineering Exclusion, there is the requirement that “the engineer’s advice focuses on a project’s engineering aspects and considerations.”  Conversely, activities outside the scope of the Engineering Exclusion are “those activities where the engineer’s advice focuses on advice relating to the structure, timing, terms, and other similar matters for the issuance of municipal securities or municipal financial products.”  The SEC issued extensive interpretative guidance on the application and limitation of the Engineering Exclusion.  Below are some excerpts from that guidance.

On New Projects

Generally speaking, on a new project to be financed by an issuance of municipal securities, an engineer can rely on the Engineering Exclusion when providing advice on the engineering aspects of a project that will be financed, in whole or in part, by an issuance of municipal securities.  However, such advice cannot cross the line into including advice with respect to structure, timing, terms, or other similar matters concerning such issuance of municipal securities.

New Project to be Financed by an Issuance of Municipal Securities. The staff believes an engineer could rely on the engineering exclusion when providing advice on the engineering aspects of a new project that will be financed, in whole or in part, by an issuance of municipal securities; provided that such advice does not include advice with respect to structure, timing, terms, or other similar matters concerning such issuance of municipal securities. For example, an engineer could provide a municipal entity or obligated person with advice on a new project’s specifications, including overall cost, a projected construction schedule, anticipated funding requirements, and a projected in-service date. The municipal entity, obligated person, or other financing transaction participant, in turn, could use such information to structure the related issuance of municipal securities, including determining the length of any capitalized interest period and the amount of capitalized interest to be financed from bond proceeds. The staff believes, however, that an engineer providing advice on how to structure the related issuance of municipal securities, including the length of any capitalized interest period and the amount of capitalized interest to be financed, would constitute municipal advisory activities outside the scope of the engineering exclusion. Absent an available exclusion or exemption, the staff believes that an engineer providing such advice would fall within the scope of the municipal advisor definition under the Final Rules and would be required to register with the Commission as a municipal advisor.

Significantly, SEC stated its belief “that the provision of engineering feasibility studies that include certain types of projections, such as projections of output capacity, utility project rates, project market demand, or project revenues that are based on considerations involving engineering aspects of a project are within the scope of the engineering exception.”  SEC also stated the following interpretation for engineers working on new projects:

Similarly, as part of providing advice on the engineering aspects of a new project, an engineer could provide a municipal entity or obligated person with projected gross revenues that are derived from the physical connections to the project (e.g., water and sewer system), as well as projected operating and maintenance expenses and net revenues for such project. The municipal entity, obligated person, or other financing transaction participant, in turn, could use such information to structure the timing and terms of debt service payments on the related issuance of municipal securities and, based on such debt service structure and projected net revenues, provide a projected debt service coverage table for inclusion in the offering document for the issuance of municipal securities. The staff believes, however, that an engineer providing advice on how to structure the related issuance of municipal securities, including the timing and terms of debt service payments, would constitute municipal advisory activities outside the scope of the engineering exclusion. 

On Existing Projects

SEC also propounded guidance for the extent of the Engineering Exclusion as applicable to engineering work on existing projects.  With regard to an existing project financed by an issuance of municipal securities, SEC stated:

An engineer could rely on the engineering exclusion when providing advice on the engineering aspects of an existing project that was financed, in whole or in part, by one or more outstanding issues of municipal securities; provided that such advice does not include advice with respect to restructuring or refinancing such issuance of municipal securities. For example, a municipal entity engages an engineer to provide a compliance report with respect to an existing project that includes evaluating the state of the physical plant, the useful life of parts, the routine maintenance being conducted, and the proposed capital improvements program and, based on such evaluation, the engineer provides the municipal entity with advice on complying with covenants in existing bond documents. In such a compliance report, the engineer may provide advice on rates and whether the proposed rate structure is sufficient, or recommend a rate increase to achieve compliance with an existing rate covenant. The staff believes, however, that an engineer providing advice on how to structure a new issuance of municipal securities for the proposed capital improvement program or restructure or refinance an outstanding issuance of municipal securities to achieve compliance with covenants in existing bond documents would constitute municipal advisory activities outside the scope of the engineering exclusion.

Although the guidance provided by SEC is not exhaustive, it can serve as a good checkpoint for A/E’s considering work on projects financed by the issuance of municipal securities.  If there is doubt regarding whether the municipal advisor registration requirements apply to an A/E on a particular project, consulting an attorney with experience dealing with SEC regulations is advisable.

The Regulatory Framework

Registered Municipal Advisors are subject to SEC rules and MSRB regulations applicable to their municipal advisory activities and are required to implement a supervisory system that includes the designation of one or more supervisory principals and written compliance procedures, and processes to maintain, review, test and modify such procedures.

The framework includes professional qualification requirements for municipal securities representatives and their supervisors who are required to pass the MSRB’s Municipal Advisor Representative Qualification Examination (Series 50). All registered Municipal Advisor employees need to take and pass the Series 50 in order to be able to engage in municipal advisory activities on behalf of the advisory firm. From experience, this exam requires 4 – 6 weeks of self-study and preparation.

The MSRB is planning to launch this coming Fall a qualifying examination (the Series 54 Examination) for municipal advisor principals — those individuals directly engaged in the management, direction or supervision of the municipal advisory activities of a municipal advisor firm and its associated persons.

 Firms offering financial advisory services to municipalities without applicable registrations and their professionals having passed the Series 50 examination are subject criminal penalties and fines, and loss of licensure.

Why Register As a Municipal Advisor?

Some A/E firms in the US are developing or creating consulting divisions alongside traditional engineering or architectural technical services, which allows them to expand their client base and differentiate themselves from their industry competitors.

A regulated market for these services evens out the playing field for such firms since smaller players and firms with mediocre reputations are less likely to now be competing in the space. For example, one of the goals of the Dodd Frank Act is to eliminate “pay-to-play” in the public sector.

Firms that compete in this space are required to disclose their registration status (which is publicly accessible on the MSRB website (http://www.msrb.org/MARegistrants.aspx). From a business development perspective, the ability to state that the firm is an SEC/MSRB registered and compliant entity that is authorized to provide municipal advisory services serves as an additional pedigree, without having to go into the more complex broker-dealer regulation framework.

However, an important point to consider is the risk of the firm’s name being associated with a body of rules very different from engineering/architecture and that the firm may not be used to implementing historically. The firm is subject to regulatory scrutiny and oversight and its information is publicly accessible.

Program of Compliance

The cost of registration and compliance with the MSRB municipal advisory regime should be evaluated against the appetite of the market and potential revenue streams from financial consultancy services provided to public agencies and municipal entities more generally.

The scope of regulatory compliance obligations is wide and complex. It is therefore recommended to engage a dedicated compliance consultant to assist in managing the firm’s regulatory compliance program, the first step being the initial drafting and implementation of the firm’s written supervisory procedures. The process is technical, lengthy, and complex and the final document is subject to regulatory review by the SEC. The written supervisory procedures describe in detail the firm’s regulatory obligations. There are a few specialized firms in this space, perhaps the most well-known is ACA Compliance Group, however none are focused specifically on A/E firms.

  • Many regulatory obligations are recurring with varied frequency (monthly/quarterly/bi-annual/annual) and time consuming as they require data collection, careful recordkeeping and document production.
  • Regular training of client-facing staff is another regulatory requirement which can be costly as it takes away revenue generating employees from their revenue generating activities, at frequent intervals.
  • From a corporate perspective, if the firm uses several operating entities for its business, clear organizational framework and guidance to employees must be implemented to ensure that only the entity that is in fact registered and authorized to provide municipal advisory services is the entity being used for such contracts. This also applies to authorized signatories for these contracts who are required to comply with individual examination, registration, reporting and training obligations.
  • In addition to staff time, compliance advisory support, and the cost of registration and examinations, the municipal advisory business being subject to regulatory oversight means that at any time, the SEC may carry out a routine audit of the firm. The process requires data gathering and drafting and may require obtaining guidance from a specialized law firm. The cost of these legal services is difficult to evaluate as it depends on the scope of the audit and the nature of the registered firm’s response.
  • Finally, adequate corporate insurance coverage should be procured to ensure the registered firms benefits not only from professional liability coverage but also financial risk.

In sum, resources expended on the municipal advisory compliance program may be significant. Generally speaking, the cost is a fixed cost regardless of the number of projects undertaken or revenue streams generated from these types of activities.

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Joseph Dennis

Arup, New York, NY and Helene Altman, Arup, New York, NY