FINRA Issues Guidance Relating to Firm Short Positions & Fails-to-Receive in Municipal Securities

FINRA issued Regulatory Notice 15-27 to remind firms engaging in municipal securities transactions that their written supervisory procedures should identify the process for detecting, resolving and preventing the consequences of firm short positions and fails-to-receive in municipal securities, as well as the controls for ensuring that communications with customers regarding municipal securities transactions, including the tax status of interest payments, are not false or misleading.

FINRA noted that their examinations have found that, as a result of trading errors and inadequate firm controls, some customers who purchased  tax-exempt municipal securities have been paid substitute interest, which is not tax exempt under the Internal Revenue Code. “Short positioning municipal securities is rare because the Internal Revenue Service will not allow both a borrower and lender of a municipal security to claim a tax exemption” and “[i]n effect, the lender of a municipal security would be trading tax exempt interest for taxable interest.”   However, recently, FINRA examiners have identified a number of instances where firms have effected sales of municipal securities to customers where either the firm’s trading activity inadvertently resulted in the firm creating a firm short position, or the firm failed to receive the securities it purchased to fill a customer’s municipal securities order, collectively referred to as municipal short positions.

Intimately, FINRA member firms need to be mindful of the additional concerns that arise when customer long positions in tax-exempt municipal securities allocate to short positions. Consequently, a customer seeking tax-exempt interest may be receiving substitute interest from the firm, which could in fact be taxable.

Municipal short positions remain an area of focus for FINRA examiners. If the firm, through a self-review process, becomes aware that the activity described in this Notice has taken place, it is important to evaluate the conduct to determine if a filing pursuant to FINRA Rule 4530 is required. In addition, the firm should consider consulting legal counsel and the appropriate taxing authorities, such as the IRS or appropriate regulatory bodies of the states in which affected customers reside, to resolve tax reporting or underpayment issues, if any.