Manual on Close-Out Procedures. Third Edition January 1985

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Manual on Close-Out Procedures

Third Edition

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Municipal Securities Rulemaking Board 1900 Duke Street, Suite 600

Alexandria, VA 22314 (703) 797-6600

www.msrb.org

Manual on

Close-Out Procedures

Third Edition

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First Edition published January 1980. Second Edition August 1981. Third Edition January 1985.

Preface ... Close-Outs by Purchasers: The Basic Procedure

Initiating a Close-Out: The Telephone Call ... Initiating a Close-Out: The Written Notice ... Executing a Close-Out: The Purchaser’s Options ... Executing a Close-Out: The Procedure ... Deliveries During the Close-Out Period ... Second or Later Notices ... The Ninety Business Day Time Limit ... Retransmittals: Close-Outs Involving Several Dealers

Notification ... Subsequent Retransmittals ... Deliveries on Retransmittals ... Close-Out Executions on Retransmittals ... Special Situations I: The Transfer Extension ... Special Situations II: Close-Outs on Reclamations ... A Last Word ... Appendices

Appendix A: Glossary of Terms ... Appendix B: Rule Text ...

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iv MSRB Manual on Close-Out Procedures

Preface

This manual outlines in question-and-answer form the provisions of rule G-12(h) (i) governing the close-out procedures available to dealers purchasing municipal securities. The text of rule G-12(h)(i) is set forth in an appendix, with each sentence indexed with references to relevant questions; also included is a glossary of basic terms. The manual sets forth the procedure as in effect as of January 1, 1985; future editions of the manual will be revised to reflect subsequent changes to the procedure, if any, as well as future Board interpretations.

The manual does not address the “seller’s close-out” provisions of rule G-12(h)(i). Persons wishing to use this procedure should refer to the text of the rule.

For explanation purposes the manual reviews the procedures from varying perspectives—from the perspective of the purchaser when reviewing the basic procedures, and from the perspective of the seller when reviewing the retransmittal procedure. Readers should be mindful of the perspective from which individual questions are written.

Chapter One

Close-Outs by Purchasers:

The Basic Procedure

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Initiating a Close-Out: The Telephone Call

1. Q: What transactions are subject to a close-out procedure?

A: Only transactions between municipal securities brokers or dealers are subject

to a close-out procedure. The close-out procedure cannot be used with respect to a transaction between a customer and a municipal securities dealer.

2. Q: Can I issue a close-out notice on any transaction between myself and another dealer?

A: To be able to issue a close-out notice on a transaction, you must have first

compared the transaction with the other dealer; that is, you must have sent a confirmation of the trade to him, and received from him a matching confirmation, or some other acknowledgement that he knows about the trade. The close-out procedure cannot be used if only one party knows the trade.

3. Q: When can I begin a close-out?

A: The earliest date for initiation of a close-out procedure is the 5th business day

following the settlement date. A transaction must be in fail for at least 5 days before you can initiate a close-out on it. You can initiate a close-out at any time after that, up to the outside time limit, which is discussed later in questions 87-92.

4. Q: Should I be sending out notices on every trade that’s open in fail on the 5th business day?

A: Remember, we said “the earliest date” you can initiate is the 5th business day.

You can issue a close-out notice on the 5th business day, if you want to, but you aren’t required to issue a notice at that time, and, in fact, most firms and banks wait a longer period of time before considering a close-out.

One practice which the Board believes should be avoided is the idea of automatically issuing a close-out notice as soon as a transaction is 5 business days old. Some dealers have considered computerizing the process of issuing notices, so that notices would be automatically printed and sent out on the 5th business day to the dealers failing to deliver the securities. The Board believes that this can be considered “harassment” of the failing dealer. The Board urges that you issue a close-out only when you have a serious intention of following through on it. Another factor to consider is that many transactions that are in fail on the 5th business day after the settlement date will clear within the next day or two. You may want to check informally on the status of the trade with the other dealer before deciding to take the step of issuing a close-out notice.

5. Q: How do I begin a close-out?

A: Beginning the close-out procedure is a two-step process. First, if you’re the

purchaser, you must call the seller, and tell him that, if he does not deliver the securities involved in the transaction by a stated date and time, you intend to close out the transaction. You must also state the time period during which you intend to execute the close-out.

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MSRB Manual on Close-Out Procedures MSRB Manual on Close-Out Procedures

6. Q: When you say “call the seller,” what does that mean? Whom should I call?

A: Every dealer has its own procedures to handle close-outs, so the Board

doesn’t require that a specific person, or a specific type of person, be contacted. You should call someone who will know what you’re talking about, a person in municipal operations, for instance. A number of dealers have the trader who made the trade contact the person he or she bought the bonds from. Whomever you call, remember that you will have to obtain the name of the person to whom you are talking. You will have to identify this person when you send written notification of the close-out.

While we’re on this subject, remember that sometimes you will be the recipient of a close-out notice. People in your office should know who handles close-outs for you and that they’re responsible for referring calls and notices on close-outs to these people. If a close-out is mishandled in your office and, due to this error, you inadvertently fail to meet certain requirements (for instance, not retransmitting the notice to another dealer on time), you will be exposed to some risk on the close-out.

7. Q: When I call the seller, I have to tell him a date and time by which he must deliver the securities if he wants to avoid a close-out. Can I tell him any date, or is there a specific date I must use?

A: Let’s presume for the moment that this is the first notice you are issuing on this

transaction. In that case, you would not be able to specify a “deadline” earlier than the close of business of the 10th business day after the day you give the telephone notice. For instance, if you call the seller on July 8, you could not specify a “delivery deadline” earlier than July 22.

8. Q: Do I have to specify the 10th business day?

A: The 10th business day is the earliest date you can specify. You can specify any

date later than that as the deadline for delivery, should you choose to do so.

9. Q: And then I’m also supposed to state a time period during which I will execute the close-out if the securities aren’t delivered? What should that be?

A: The rule requires that you specify the day or days during which you intend to

execute the close-out, and permits you to specify a period of up to 5 business days for that purpose. If you specified the 10th business day after the telephone notice as your “delivery deadline,” your “execution period” could then be the 11th through the 15th business days after the notice. To follow our example, if you call the seller on July 8, and you specify a “delivery deadline” of July 22, you can specify as your execution period July 23 through July 29.

10. Q: What happens if I specify as an “execution period” only one or two days?

A: Then those are the only days on which you can execute that close-out notice.

It is important to be careful when specifying dates on close-out notices. Whatever dates or days you specify for the execution period are the only dates or days you will have available to you to act on the notice. If, through mistake or oversight, you specify only one or two days, you will be able to execute the notice only on those days. If you want the full 5 business days, you must make sure to specify the full 5 days.

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11. Q: Don’t you count July 22 (the 10th business day) as one of the days in the “execution period?”

A: No. Remember that your deadline cannot be earlier than “the close of business

of” the 10th business day after the telephone call. You could not execute the notice on the 10th day.

12. Q: You said earlier that you were assuming that this was the first notice I’m issuing on the transaction. What happens if it’s the second or third notice I’m issuing?

A: The time period you have to wait before the deadline is shorter. We’ll discuss

that later, in response to question 82.

13. Q: Let me review this. If I want to initiate a close-out procedure, the trade has to be with another dealer, and it must have been compared. I can start a close-out on the 5th business day after settlement date, and I do it by calling the seller and stating my intention to close out the trade. I have to tell him that if he doesn’t deliver me the securities by a stated date (at least 10 business days after the day I’m calling) I may execute a close-out. I also have to tell him the dates which I am reserving for this close-out execution, which can be up to 5 business days. Is that correct so far?

A: Yes, that’s right.

Initiating a Close-Out: The Written Notice

14. Q: Once I’ve called and given the notice over the telephone, what do I do?

A: Once you’ve called the seller, then you have to send a written notice confirming

your intention to close out the trade.

15. Q: When do I have to send that?

A: The rule says “immediately… after” the telephone call. This is defined earlier

in the rule to mean not later than the following business day.

16. Q: How do I have to send that?

A: That notice has to be sent “return receipt requested.” That means that, if you

send the notice by hand, the messenger should get a stamped or signed receipt when he delivers the notice to the seller. If you send the notice by mail you should use certified or registered mail, or something similar, on which you will receive a receipt card.

17. Q: Do I have to have possession of the receipt? Some services are available that deliver items and have the receiving party sign a receipt, but that receipt is retained by the service and not sent back to me as the sender. Can I send a notice by means of one of these services?

A: The purpose of the receipt is, obviously, to substantiate that you delivered the

written notice, should questions or problems subsequently arise. If the service is obtaining a receipt, and if you can get access to that receipt should you need to (e.g., if you can obtain a photocopy of the receipt upon request), then delivering

close-out notices by means of the service would be acceptable.

18. Q: What has to be in the written close-out notice?

A: The rule requires a number of items of information to be contained in the

notice, as follows:

1. Your firm’s or bank’s name.

2. The name and address of the dealer you’re sending the notice to.

3. The name of the person to whom you spoke when you provided the telephone notice of the close-out.

4. The date you gave the telephone notice.

5. A description (including the par value amount) of the securities involved in the transaction that you’re giving the close-out notice on.

6. The trade date and settlement date of the transaction. 7. The price and total dollar amount of the transaction.

8. The deadline by which the seller will have to deliver you the securities if he wants to avert the close-out.

9. The date or dates during which you can execute the close-out.

10. Your name and telephone number, or the name and telephone of someone else the seller can contact about the close-out.

19. Q: Isn’t there a standard form that I’m required to use?

A: No. The Board decided that establishing minimum requirements for the

contents of the notice would be sufficient, and that it wasn’t necessary to make everyone use the same form. A suggested form what you might want to use appears on the next page.

20. Q: Would it be acceptable to use a uniform form such as the NASD’s “Buy-in” form?

A: Use of such a form would not be permissible unless references to the

close-out rules of another self-regulatory organization are deleted or omitted from the form. If the notice which you use contains a statement that the close-out is being conducted in accordance with rules that don’t apply to close-outs on municipal transactions, that notice is void, and you would have to reissue a new notice. A form modeled on the NASD form would be fine, as long as all of the required information is provided.

21. Q: I have a few questions on some of the items you mentioned. You said that notice should include the name and address of the dealer I’m sending the notice to. If the dealer has several offices, what address should I send the notice to? The main office?

A: Again, different dealers have different practices, so it’s impossible to specify a

hard-and-fast rule. As a general matter, though, you should assume that, unless you know otherwise, you want to get the written notice to the person you spoke to on the telephone. That person knows about the close-out, knows the written notice is coming, and presumably knows how it should be handled or to whom it should be directed. Therefore, unless you know that the notice should be sent

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elsewhere, it’s best to send it to the address or the office at which the person to whom you spoke is located. For instance, if you spoke to someone in the Dallas office, you should probably direct written notice there, even though the firm might be headquartered in Houston.

22. Q: You also mentioned a “description of the security.” Some municipal descriptions can get pretty detailed—do I have to have all of the descriptive information that might be required for a confirmation, for example, duplicated on the close-out notice?

A: Remember that you’re issuing the close-out on a transaction that both you and

the seller have already agreed on and compared. The information you provide about the transaction is intended to make sure that the seller can identify the transaction you’re talking about. Therefore, you would have some flexibility to abbreviate this description, as long as you’re providing sufficient information to identify the transaction.

23. Q: The deadline and the dates for execution of the notice you mentioned— those are the dates I specified earlier, on the telephone, right?

A: That’s correct. Those are the dates we discussed in questions 7 and 9 earlier.

24. Q: Suppose I have problems in delivering the notice. Does that affect the timing of the close-out?

A: No. The timing of the close-out procedure depends on the date of the telephone

call, and not on the date the written notice is presented. Problems in delivery of the written notice would therefore not affect the procedure, presuming, of course, that both parties agree about the timing of the telephone call.

In general, should you have problems in delivering a notice, it’s best to contact the person you had previously spoken to (whose name is on the notice) and determine from him or her how the notice should be delivered. Sometimes it’s sufficient simply to arrange that the notice be delivered directly to that person.

25. Q: One problem I’ve experienced in the past when delivering notices is the seller refusing to accept the written notice when it’s been presented to him at his office. For instance, if I have a messenger deliver the notice to him “over the window,” the person at the delivery window would refuse to take the notice from the messenger. This has happened when I put on the notice the name of the person I spoke to on the telephone, and they claim that they don’t know anyone by that name. Is this proper?

A: It is never proper to refuse to accept a written notice of close-out. If the seller

believes that there is a deficiency in the notice he can call you and question that, but he should never refuse to accept the notice when it’s presented.

26. Q: What about deficiencies in the notice? Suppose I figure the dates incorrectly, or make some other mistake. What should be done?

A: Remember that you are confirming a close-out notification you have already

given over the telephone. The written notice should be providing the seller with information confirming (1) what transaction is involved, and (2) what the terms

[Name and Address of Municipal Securities Dealer]

Notice of Close-Out

Date: ___________________________ To: ___________________________

___________________________ ___________________________ ___________________________

Attn: ___________________________

Re: _________________________________________________________________________ (Quantity and Description of Security)

_________________________________________________________________________

(Interest Rate) (Maturity Date)

which is due from you to the undersigned on a contract made on

__________________________ at ___________________________ for settlement

(trade date) (contract price)

___________________________ vs. ___________________________.

(settlement date) (contract amount)

We hereby notify you that unless you make delivery of the above-described securities before the close of business on ___________________________ we intend to close out this

(date)

transaction pursuant to the provisions of Municipal Securities Rulemaking Board rule G-12(h)(i) during the period from ___________________________ to ___________________________.

(date) (date)

___________________________ of your organization was contacted on (name)

___________________________ regarding this notice. (date)

[Name of Municipal Securities Dealer] by: ___________________________ telephone #: ___________________________

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of the particular close-out procedure are. If a notice is missing some information about either of those terms, or if it is completely unclear about them, the seller can demand that he be provided with a satisfactory notice.

27. Q: Would that be true for minor mistakes like misspellings, etc.?

A: If the mistakes were minor in nature, and didn’t cause problems with identifying

the transaction or understanding the notice, then the notice should be considered to be in proper form.

28. Q: If a seller thinks there is something wrong with a notice, does he have to let me know about that by any specific time?

A: No, there is not specific time limit by which he would have to advise you of any

problem. However, he should let you know about the problem within a reasonable period of time. He shouldn’t delay until you are about to execute the close-out and then say, “hold it; I don’t think your notice meets the requirements.”

29. Q: Should I keep a copy of my notice and the return receipt?

A: Yes. You do have record retention requirements to meet (copies of written

communications on close-outs must be retained three years) and, of course, you will need to keep track of each close-out procedure while it’s still active.

It’s important that you monitor the status of a particular close-out procedure, to ensure that any time extension, which we’ll discuss below, is properly recorded, and that you take action at the appropriate time. Many dealers are keeping track of procedures, both for notices they send out and notices they receive, by maintaining copies of the notices in “tickler” files by date, so that someone is alerted about a particular close-out several days before action needs to be taken on it. This assures that notices won’t be overlooked.

30. Q: Let me summarize again. Not later than the business day after I’ve given notification of close-out by telephone, I have to send a written notice confirming my telephone call. That notice has to have certain specified items of information on it. That notice has to be sent return receipt requested, and I have to keep a copy.

A: That’s right.

Executing a Close-Out: The Purchaser’s Options

31. Q: So far I’ve called with my telephone notification of close-out, and I’ve sent out my written notice. What’s next?

A: The rule recognizes three kinds of close-out situations. The first is the relatively

simple situation where only two parties, a purchaser and a seller, are involved, and the seller’s failure to deliver is caused by some factor other than the submission of the securities for transfer. The second is a more complicated situation in which three or more dealers are involved, and there is a string of related fails to deliver on the same securities. The third is an unusual variant of the two-party close-out, the special situation in which the securities which the seller has failed to deliver have been submitted to the transfer agent. Let’s start by following the simple

version of the two-party close-out first. Once we have the down we can take a look at the more complicated versions.

In the simple two-party situation, once you as the purchaser have given the telephone and the written notice of close-out, the rule does not require anything further to happen until the deadline and the execution dates arrive. (As we’ll see later, in question 157, this is the point at which the more complicated two-party close-out situation, where the securities have been submitted for transfer, becomes different from the simple version.)

32. Q: Doesn’t the seller have to come back to me and tell me what’s going on, why he’s failing to deliver?

A: In most cases, no, the seller is not required to respond to you. Most industry

members try to provide information on the status of fails, and, of course, dealers issuing close-out notices frequently delay taking further action on the notices if they are kept informed about what’s happening on the delivery and why it is in fail. The Board wanted to keep the close-out procedure simple so it did not provide a specific requirement for this kind of response; it’s always a good idea, though, for the seller to keep the purchaser informed on the status of the transaction.

In the more complicated two-party close-out procedure, however, where the securities have been submitted for transfer, the seller is required to respond to you concerning the reason for the fail. This is reviewed in detail in questions 157-160.

33. Q: So we’re now at the deadline for delivery and the seller hasn’t come up with the bonds. What are my choices in executing the notice?

A: The rule permits you to choose one of three ways of executing the notice, as

follows:

1. purchase (“buy in”) all or part of the bonds at the current market price for the account and liability of the seller;

2. accept from the seller substitute securities agreeable to you, with the seller bearing any cost associated with substituting them; or

3. make the seller repurchase the bonds on terms that include accrued interest and that make him bear any market change.

Note, also, that you have the choice of not executing the notice at all. If the seller advises you that he expects to deliver the securities in the next few days, or if, for some other reason, you feel that it would be appropriate to work with the seller to get delivery of the securities, you can permit the notice to lapse.

34. Q: What happens if I do that?

A: We’ll cover that later on, in questions 80 through 86.

35. Q: I’d like to discuss each of the execution options in turn. How would the “buy-in” option work?

A: Your traders would go into the market, find someone who has the bonds for

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used to satisfy your contract with the seller, and the seller would have to pay any costs you incurred on the transaction.

36. Q: Such as?

A: Well, if the initial contract on the bonds was at 95, and the buy-in was executed

at 100, the seller would pay the 5 points differential. He would also have to pay the difference in accrued interest.

37. Q: You said that I could buy in “all or part of the bonds.” Does this mean if I have a trade for 100 bonds, with 50 owed to a customer and 50 in trading inventory, my trader could buy in the 50 for the customer, and leave the fail open for the other 50?

A: No. The language of the rule is “all or any part of the securities necessary to

complete the transaction.” If you have a fail of 100 bonds your trader would have to buy in the full 100, or, if the seller can deliver you a partial of 50, you can accept his 50 and buy in the other 50 to complete the trade.

38. Q: Since you mention partials, do I have to accept his 50 in your example?

A: No, you have the option of accepting the partial or executing a close-out for

the full amount. If you can work with the seller and take the partial, it is, of course, preferable that you do so. You are not required to accept the partial, however. (Note, however, that in a multi-party close-out there might be circumstances in which you would be obliged to accept what you would consider a partial delivery. This is discussed in questions 155 and 156.)

39. Q: One last question on partials—If I do accept a partial, and have some bonds left in fail, do I have to start the close-out process all over again for the remaining fail, or can I proceed on my original notice?

A: You can proceed to buy in the remaining balance on the strength of your

original notice. You don’t have to start the process all over again.

40. Q: Are there any restrictions on the people from whom my trader can buy in the bonds?

A: The rule expressly permits a buy-in on the bonds from long positions in

customer accounts you maintain. If your trader buys in the bonds from the person to whom the bonds were sold, you have to get the seller’s consent. Otherwise there are no restrictions on the party from whom you may buy them.

41. Q: The second option, substituting securities, is somewhat unusual. Do you mean I can tell the seller, “I want X bonds, go buy them?”

A: No. This option requires negotiation between your trader and the seller. The

option provides that you may “accept” substitute securities, so the seller has to agree on what securities are being substituted.

42. Q: And if the seller doesn’t agree or my trader doesn’t agree with what the seller wants to substitute?

A: Without an agreement between the two parties the substitution option can’t

be used, and one of the other options must be selected.

43. Q: If we do agree on the securities to be substituted, how do we go about the substitution?

A: A substitution of securities involves negotiation and agreement on all the details

of the transaction—securities, contract prices, settlement dates, etc. Confirmations should be exchanged on the substitution, and the original transaction should be concurrently cancelled. Any additional expenses or costs must be borne by the seller.

44. Q: The last option is a mandatory repurchase. How does that work?

A: You require the seller to repurchase the securities from you on terms so that

he (1) makes up the accrued interest, and (2) bears the burden of any change in the market.

45. Q: What does “bear the burden of any change in the market” mean?

A: Well, as a practical matter, if you have a contract at 100, and the market is

down to 95, you force the repurchase at 100, so that he “bears the burden” of the down market. Conversely, if you have a contract at 100, and the market is up to 105, you can force the repurchase at 105, so the seller again “bears the burden” of the market shift.

46. Q: Suppose, in your example of a down market, I had sold those bonds to a customer at 101 after buying them from the selling dealer at 100. Could I force the seller to repurchase the bonds at my 101 contract price to the customer?

A: No. You can only put the bonds back at the inter-dealer contract price. The

seller cannot be held liable for the amount of any retail mark-up.

47. Q: Suppose, again in the case of a down market, I am seeking to have the other dealer repurchase at the contract price securities that I bought from him at a yield price. Do I use the original dollar price on the trade, or do I use the original yield price figured to the new settlement date of the repurchase transaction?

A: You can use the original yield price figured to the new settlement date. Note

that in the case of a security trading at a premium the seller can force you to use the yield price figured to the new settlement date.

48. Q: One thing that could be a problem is the price at which the buy-in or the mandatory repurchase occurs. Is there any check that the price represents a fair market for the bonds?

A: The rule provides that the purchaser must always be prepared to defend the

price at which the close-out is executed, so if your trader executed a buy-in at a price that was high relative to the market, the seller could challenge you on the validity of that price. Note that, in the case of a forced repurchase in a down market, a demonstration that the repurchase was put through at the original contract price would be sufficient to meet this requirement.

49. Q: What happens if the seller challenges the price?

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would have to go to arbitration.

50. Q: Is that true of other disputes about aspects of a particular close-out procedure? I can take these to arbitration as well?

A: Yes. Disputes where one of the parties to a close-out feels that it has been

significantly injured can be taken to arbitration, if the party is unable to work out a suitable resolution of the problem with the other parties involved. Information about the Board’s arbitration code can be obtained from the Board’s office.

51. Q: Sometimes I just want to get the trade off my books, and I would be perfectly happy to cancel the transaction without any payment of funds, or perhaps only payment of an accrued interest differential. Can I do this?

A: The last option, the mandatory repurchase, permits you to require the seller to

buy the bonds back at the contract price plus accrued interest. This would be the equivalent of what you’re suggesting. If you were willing to forego the accrued interest differential as well, that would also be permissible. The parties to a close-out can agree among themselves to cancel transactions at the original contract moneys, should they so desire.

52. Q: Suppose I have the bonds bought at 100 and sold to a customer at 101, and the market for the bonds has declined to 95. If I can locate the bonds elsewhere in the market, can I execute a close-out against the seller, and cover the bonds in at the lower price, retaining the differential for myself?

A: Absolutely not. The close-out procedure is intended to provide a mechanism

for speeding up deliveries and clearance of transactions, not for making additional profit on a trade. Besides, as we’ll see in question 63, in that situation you would be considered to be executing a “buy-in,” and would have to send the differential between the two prices to the selling dealer.

53. Q: I think it’s time for a review again. I have three options to execute a close-out: a “buy-in,” a “substitution,” and a “mandatory repurchase.” On a “buy-in,” I go into the market and buy the securities from another dealer, and the seller has to bear the additional expense involved. On a “substitution,” the seller and I negotiate on replacement securities, and the original contract is cancelled once the substitute transaction is put through. On a “mandatory repurchase,” I require the seller to reverse the transactions by buying the securities back from me at a price that makes him absorb whatever has happened to the market. The seller has the right to challenge the price at which I execute the close-out, and, if he does, I have to substantiate that the price is fair.

A: That’s correct.

Executing a Close-Out: The Procedure

54. Q: Those are my choices in executing a close-out notice. What do I actually have to do?

A: Once the specified day or days arrive, your trading desk or some managerial

person at your firm or bank should determine which of the options you’re going to use and what action should be taken on the trade.

55. Q: Do I have to tell the seller beforehand, when I send him the original notice, which option will be used?

A: No. You don’t have to select the option for execution of the close-out until the

actual day for execution.

56. Q: Let’s suppose it’s decided to have the seller repurchase the bonds. What has to be done?

A: 1. Your trader should put through a ticket selling back the bonds at the

appropriate price.

2. Once the close-out has been executed, the seller must be notified by telephone of the fact that the execution has taken place, and the manner in which you executed the close-out.

3. You have to confirm this notification in writing by the next business day, and send that to the seller, return receipt requested.

4. You must also forward the seller a copy of the confirmation of the transaction you put through to close out the trade.

57. Q: Should that confirmation sent on the close-out be identified as an execution of a close-out?

A: Yes. Board rules require that information necessary to ensure that both parties

agree to the details of a transaction must be included on a confirmation of the transaction. Under this requirement the confirmation should be designated as a confirmation of a transaction to effect execution of a close-out.

58. Q: If these securities were brought in from a customer, the confirmation would obviously identify the customer. Could I block out or otherwise delete the customer’s name from the copy of the confirmation sent to the seller?

A: Yes. The confirmation is intended to evidence the terms of the transaction

put through to execute the close-out. The customer’s identity is not necessary for this purpose and therefore may be withheld. If the close-out is challenged in arbitration, however, the customer might have to be identified.

59. Q: If my trader puts through a buy-in trade or a repurchase trade, do I have to do it on a “cash” basis for settlement on the trade date?

A: No. The Board recognizes that in many cases the securities will not be available

for same day delivery, or it will be impossible to reinvest a customer’s funds for same day settlement. Therefore there is no requirement to execute the close-out on a “cash” trade basis.

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16 17

60. Q: Does it have to be done on a “guaranteed delivery” basis—that is, does the party who is selling me the securities on the close-out execution have to be able to guarantee me that he will deliver the bonds on the settlement date?

A: No. Since the point of the close-out procedure is to obtain the securities, you

may wish to execute a buy-in with this “guaranteed-delivery” stipulation. You are not required to obtain such a guarantee, however.

61. Q: What about the settlement on the money due? How is that figured?

A: When you notify the seller that the transaction has been closed out, you also

inform him of the way in which you closed out the transaction, for example, “I brought you in a 95.” This information is also provided in the written notice on the execution sent the following day. By comparing the price and dollar amount of the close-out execution to his original contract amount, the seller will be able to determine how much he owes on the close-out execution, if anything. For example, if the original contract was at 90, with 30 days of accrued interest, and the buy-in was executed at 95, with 90 days of accrued interest, the seller would owe you 5 points, plus 60 days of accrued interest.

62. Q: When must that be paid?

A: The rule requires that any money balances due on close-outs or closed-out

transactions must be sent to the appropriate party by 10 business days after the date of execution of the close-out. Therefore, if the seller owes you 5 points plus 60 days accrued interest, as in our example, he would have to send you a check for that amount within 10 business days. Conversely, if you owe the seller money, you would have to send it to him within 10 business days.

63. Q: If I owed the seller money? How could that happen?

A: Remember that when you execute a buy-in, it’s “for the account and liability

of the seller.” That means that, if you have to pay more for the securities when you buy them in, the seller has to pay the differential. Conversely, though, if the market for the bonds has declined, and you buy the bonds in at a price that’s cheaper than the original contract price, the seller gets the benefit of that, and the differential should be paid to him.

Let’s follow our example through. Assume you bought the securities from the seller at 95, with 30 days of accrued interest. If the market declines to 90, and you buy in the securities at that price, plus 90 days accrued interest, you would owe the seller 5 points, less the 60 days differential in accrued interest.

64. Q: That doesn’t seem fair.

A: It seems unfair only because you’re forgetting that the seller is left with an

inventory position in the securities that he had previously sold. The object of the rule is to facilitate clearance of transactions and deliveries of securities, and the rule tries to do that without causing any dealer to absorb costs or losses that aren’t necessary. In the case we’re discussing, when the contract was executed at 95 and the buy-in at 90, the seller will be left long securities which he had originally sold at 95 at the new market level of 90. The 5 point reimbursement, however, adjusts

the cost basis at which he owns those securities to the current market level, and, therefore, he does not absorb any unnecessary loss.

65. Q: What about substitutions or mandatory repurchases? How does the money settlement work on those?

A: Well, substitutions are negotiated, remember, so that if any money settlements

were involved they should be agreed upon during the negotiation. Mandatory repurchases are handled in much the same way as a buy-in. The seller is advised of the price of the mandatory repurchase at the time of execution, compares that price to the price of his original contact, and pays the difference within 10 business days.

66. Q: Or he gets paid the difference, if the repurchase is at a lower price?

A: That’s unlikely to happen. Remember that the rule provides that the seller

can be required to repurchase the securities at a price which makes him bear the burden of any change in the market. If the market has declined, he can be required to repurchase at the original contract rather than the lower price, so that he “bears the burden” of the decline.

67. Q: Doesn’t that cause him to absorb a loss?

A: Yes, it could. The rule tries to avoid causing the seller to absorb an unnecessary

or avoidable loss, but it recognizes that sometimes the loss can’t be avoided. Since many municipals aren’t widely available in the market, and can’t be bought in, other methods of completing close-outs have to be provided. These other methods can’t always resolve the transaction as cleanly as a buy-in can. Sometimes, therefore, the seller will have to bear some loss on the close-out of the transaction.

68. Q: What happens if a dispute arises about the fairness of the close-out execution price? Am I still obliged to send out any moneys owed on the close-out execution within 10 business days?

A: No. If the close-out execution price is disputed, the settlement of the money

amounts due should be deferred until the dispute is resolved.

69. Q: Let’s review again. When I execute a close-out, I have authorized people (traders, for instance) decide what to do, and put the execution transaction through. I have to tell the seller by telephone that I executed the close-out, and how I did so. Then I send him a written notice confirming the call, with a copy of my confirmation of the transaction executing the close-out. That notice has to be sent by the next business day, return receipt requested. Any money due on the close-out, from the seller to me or from me to the seller, has to be sent within 10 business days of the execution date.

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Deliveries During The Close-Out Period

70. Q: Let’s go back for a minute, before I’ve actually executed a close-out. Suppose, as in your earlier example, the dates on which I could execute the notice are July 23 to July 29. On July 23 my traders go into the market and buy in the bonds. If the seller tries to deliver the securities on that morning, after we’ve executed the buy-in, am I obliged to accept delivery?

A: Not unless the seller has given prior notice of his intention to make delivery.

If the seller can complete the transaction, he can provide you notice that he will deliver the securities within 2 business days. If he gives you such notice, that would suspend the close-out procedure for those 2 days.

71. Q: But if he doesn’t give that notice, and I’ve executed the close-out, my execution is valid and I can reject the delivery.

A: That’s correct.

72. Q: Suppose the seller delivered the bonds on July 23, but before I executed the notice. Should I accept the delivery?

A: Yes, in that case you should.

73. Q: Suppose I’ve just executed the close-out, and I call him to notify him that I’ve executed it, as I’m required to do. Can he say, “Wait a minute, I’ve got the securities, I’ll deliver tomorrow,” and suspend the close-out in that way?

A: No. The rule permits the seller to suspend action on the close-out so that, if the

securities finally become available just before or during the close-out execution period, he has the opportunity to avert the close-out and make the delivery. You have the right to take action on the close-out at any time during the execution period, however, so, if you have already executed the close-out, he is no longer able to “freeze” or suspend action on your notice.

74. Q: Suppose the seller calls and gives notice of delivery, and then doesn’t deliver?

A: The close-out notice still remains in force. If the seller has given notice of

delivery, and then fails to deliver the securities during the stated delivery days, you could proceed with the close-out.

75. Q: Can he deliver at any time during the specified delivery days, or does he have to deliver during the standard delivery hours?

A: If he delivers the securities on the second day you should still accept the

delivery even though it may be after standard delivery hours. This is true even if delivery will occur late in the day.

76. Q: Let’s say my execution dates are July 23 to July 29. On July 27 the seller calls me and tells me he will be delivering the securities sometime over the next 2 days, July 28 or July 29. Those are the last 2 days of my execution period—if he doesn’t deliver, can I still close him out under this notice?

A: Yes. If the seller promises delivery and suspends action on your close-out for

2 days, the dates for execution of your notice are extended an equivalent 2 days. If he “freezes” your notice for July 28 and 29, your notice will be effective, and a close-out can be executed, during July 30 and 31, as is illustrated below. (Note also that if the seller calls to promise delivery on the last day of the execution period (July 29, in our example), the effective dates of your notice are extended by three business days (July 30, 31, August 3), so that you are sure to have time to execute the notice if he doesn’t deliver).

77. Q: Is that true even if the days he is reserving for delivery are not the last 2 days in my execution period?

A: Yes. If your execution period is July 23 to July 29, and the seller promises

delivery and “freezes” your notice on July 23 and 24, you still get the 2 day extension, and the notice is effective on July 30 and 31, as is shown on the next page. That way you always get the full number of days you specified for your execution period.

1 2 3 4

5 6 7 9 10

27 26

19

15

22 20

14 12

21

13 16

23

17

24

11

18

25 8

JULY

28 29 30 31

EXECUTION PERIOD

EXTENDED EXECUTION PERIOD FREEZE PERIOD

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20 21

78. Q: Can he “freeze” my notice more than once?

A: No, the seller can suspend execution of a particular close-out notice only one

time. If he does not deliver the securities during those 2 days, the notice becomes effective again, and he can’t prevent your taking action on it.

79. Q: Time for a review again. If the seller finally obtains the securities, he can “freeze” action on an outstanding close-out notice by calling me, as the purchaser, and advising me that he will deliver the securities during the next 2 business days. In that case I cannot take action on the notice during those days, and, if the seller delivers, the notice expires. The 2 business days also extends my period for executing the close-out, though, so if the seller doesn’t deliver the securities during those days, I can proceed to close out the transaction.

A: That’s right. Remember, the seller can suspend action on the close-out only

once on a particular notice.

Second or Later Notices

80. Q: I don’t absolutely have to execute the close-out though, do I? For instance, back in question 33 you said I could allow the notice to lapse. What happens if I don’t execute the close-outs?

A: As we said earlier, each notice is good only on its terms and for whatever day

or days are specified on it. If, for example, your notice is good for the period of July 20 to July 24, you must take action during that time. If you don’t, the notice lapses and is no longer valid.

Sunday Monday Tuesday Wednesday Thursday Friday Saturday 1

2 3 4 6 7

24/31 23/30 16 12 19 17 11 9 18 10 13 20 14 21 8 15 22 5 AUGUST

25 26 27 28

EXECUTION PERIOD DEADLINE 2ND PHONE CALL 29

81. Q: That doesn’t mean that I’ve lost my chance to close out the transaction, does it?

A: No, you can issue another notice or several more notices, if you wish.

82. Q: And I proceed with those in the same way?

A: Pretty much the same, yes. The only major difference is that the waiting period

between the day you give the telephone notice of the close-out and the delivery deadline you can specify for delivery of the securities is shorter. Remember we discussed earlier, in question 7, that, on the first notice, you could not specify a delivery deadline earlier than the 10th business day after the date of your telephone call about the close-out. On the second notice issued on a transaction, however, and any notice after that, you can specify a delivery deadline of 5 business days after your phone call.

83. Q: Can you give an example of that?

A: Suppose you had issued your notice in July, as we had discussed earlier. For

whatever reason, you let that notice expire without taking any action on it, but now you want to start up the close-out procedure again. If you call the seller on August 5, you can advise him that if he does not deliver the securities by the close of business on August 12, you will close the transaction out during the period August 13 to August 19.

84. Q: Whereas if this had been the first notice I would have had to wait until August 19 for the delivery deadline, and August 20 through August 26 for my execution period.

A: That’s correct. Since you had already issued a notice on this transaction and

this is a second or subsequent notice, the notice becomes effective more quickly.

1 2 3 4

5 6 7 9 10

27 26 19 15 22 20 14 12 21 13 16 23 17 24 11 18 25 8 JULY

28 29 30 31

EXECUTION PERIOD EXTENSION FREEZE PERIOD

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85. Q: If my second notice becomes effective (on August 13, as in your example), can the seller put the 2-business-day “freeze” on its execution?

A: If he can promise delivery of the securities within that time, yes.

86. Q: This business of second or later notices seems so simple, I don’t know if we have to review it.

A: That’s right. Second or later notices can become effective at an earlier time

than first notices (5 business days after the telephone call), but otherwise they should be handled in the same way.

The Ninety Business Day Time Limit

87. Q: And that’s all there is to the basic procedure?

A: There’s one important item left. Under ordinary circumstances you cannot issue

a close-out notice on a transaction after the 90th business day after the settlement date. After that time you generally lose the ability to issue close-out notices.

88. Q: That’s only if I haven’t issued a notice before that time, right? I can issue a second or third notice on a transaction after 90 business days, can’t I?

A: No, you cannot. The absolute last day you can issue a notice is that 90th

business day. If you don’t have a notice outstanding, and you don’t issue a notice on that day, you lose your chance to close-out that transaction.

89. Q: Suppose I issue a notice on day 89, that won’t become effective until day 95. Can I proceed on that notice, or is that notice void?

A: The 90 business day time limit applies to the issuance of the notice. A notice

that is issued on or prior to day 90, therefore, is issued within the time limit, and is valid, even though it may become effective after that time.

90. Q: But once the time limit is past, I can only proceed with a close-out if I have a notice outstanding?

A: That’s generally correct. Remember that you must state a deadline for delivery

of the securities when you issue a close-out notice, and you must state the dates during which you may execute the notice. If you issue a second notice on day 90, then, with a delivery deadline of day 95, and effective dates of day 96 through day 100, that’s your last chance. You will have to take action during that execution period if you want to close out that transaction. If you don’t, and that notice lapses, you can no longer close out the trade.

91. Q: You said earlier that “under ordinary circumstances” the 90 business day time limit applies. Does that mean that there are situations in which a close-out can be issued after that time?

A: There is one limited type of situation in which a close-out notice can be issued

after the 90th business day following the settlement date of the transaction. That is the case where a delivery on a trade has to be reversed—“reclaimed” is the usual term—because of a problem with the securities delivered. This situation is discussed later on, in questions 172-188.

92. Q: This time limit sounds serious. So after the 90th business day after settlement date on a transaction I generally will not be able to issue a close-out notice?

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Chapter Two

Retransmittals:

Close-Outs Involving

Several Dealers

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Notification

93. Q: Let’s look at the multi-party close-out now. When does this begin to differ from the procedure we just reviewed?

A: The differences begin at the time the selling dealer receives the close-out and

determines the reason for his failure to deliver.

94. Q: So the beginning of the procedure—the telephone call by the purchaser, and his sending of the written notice of the close-out—is the same as we’ve discussed?

A: Yes. The beginning of the procedure remains the same as described in

questions 1 through 30.

You’ll remember that in question 31 we agreed to assume that only two dealers, a purchaser and a seller, were involved in the close-out. This would be the case, for example, if the selling dealer had the securities certificates out to have a mutilated coupon validated. It’s not uncommon, however, for more than two dealers to be involved, with the seller who first receives the close-out having failed to deliver the securities because he hasn’t yet received them from a dealer who had previously sold them to him. This is where the concept of “retransmittal” comes in.

95. Q: What is a “retransmittal?”

A: A “retransmittal” is the way in which a selling dealer can pass along the potential

exposure on a particular close-out to another dealer that owes him the securities. Obviously, if the seller has the securities owed to him by another dealer, he’s not the party who is at fault—he didn’t cause the failure to deliver—so he shouldn’t have to suffer the consequences of the close-out. So the rule permits him to pass along, or “retransmit,” the notice to the dealer who’s failing to him.

96. Q: How is that done?

A: Let’s set up an example and see how it operates in practice. Let’s assume that

a block of municipal bonds has been traded among five dealers, “A,” “B,” “C,” “D,” and “E,” for final settlement October 28. We’ll make you dealer “D” in this example.

Dealer

A

Dealer

B

Dealer

C

Dealer

D

Dealer

E

It’s now November 4, settlement date plus 5 business days, and dealer E, the ultimate purchaser, has just issued you, dealer D, a close-out notice. He has told you that if you do not deliver him the bonds by November 18, he will execute a close-out during the period November 19 to November 25. You check what the problem is, and find out that you have a fail to receive on the bonds from dealer C.

97. Q: That is all happening on November 4?

A: That’s right. Let’s keep a calendar in front of us also, so we can keep track of

the dates.

Once you have identified that you are failing to receive the bonds from dealer C, you can retransmit the close-out notice to him.

98. Q: How do I do that?

A: Pretty much the same way you would originate a close-out notice. You make

a telephone call to dealer C, advising him of your intent to retransmit the notice of close-out issued by E to him, and stating the deadline date for delivery of the bonds, and the dates on which the close-out can be executed.

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28 29

1 2 3 4 5 6 7

8 9 10 12 13

30 29 22 18 25 23 17 15 24 16 19 26 20 27 14 21 28 11 E CALLS D DEADLINE THANKS-GIVING EXECUTION PERIOD NOVEMBER

99. Q: Any time limit on when I retransmit the notice?

A: Yes, and it’s a strict one. You must retransmit the notice to C, if you’re going to

do so, by the close of business on the business day following the day on which you received the telephone notice.

100. Q: So if, as in our example, I received the telephone notice from E on November 4…?

A: You must have retransmitted that notice to C by the close of business on

November 5, as is shown at the top of the opposite page.

101. Q: But it’s sufficient to give the telephone notice of the retransmittal by that November 5 time limit?

A: That’s right. The telephone call retransmitting the notice must be made within

the required time frame.

102. Q: The dates that I specify in my call to C—are those the same dates that E specified in his phone call to me?

A: No. The major distinction between two-party outs and multi-party

close-outs comes into play here. The first time a close-out notice is retransmitted all of the dates applying to that notice—the deadline date for delivery of the securities, and the dates during which the close-out may be executed—are extended by 5 business days. The selling dealer gets an additional 5 business days to deliver the bonds, and the execution period for the close-out begins 5 business days later than originally specified.

103. Q: What does that mean in terms of our example?

A: Well, when E initiated the close-out to you, he specified November 18 as the

delivery deadline, and November 19 to November 25 as the execution period. That produced the situation illustrated on the bottom of the page.

When you retransmit to C, that extends the delivery deadline to November 25, and the execution period becomes November 27 to December 3. That is illustrated on the next page.

1 2 3 4 5 6 7

8 9 10 12 13

30 29 22 18 25 23 17 15 24 16 19 26 20 27 14 21 28 11 CALL FROM E NOVEMBER CALL TO C

1 2 3 4 5 6 7

8 9 10 12 13

30 29 22 18 25 23 17 15 24 16 19 26 20 27 14 21 28 11 E CALLS D DEADLINE THANKS-GIVING EXECUTION PERIOD NOVEMBER

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1 2 3 4 5 6 7

8 9 10 12 13

30 29

22

18 25 23

17 15

24

16 19

26

20 27

14 21 28 11

E CALLS

D

NEW

DEADLINE THANKS-GIVING NOVEMBER

D CALLS

C

1 2 3 4 5

NEW EXECUTION PERIOD DECEMBER

Dealer

A

Dealer

B

Dealer

C

Dealer

D

Dealer

E

NOTICE OF EXTENSION RETRANSMITTAL

104. Q: So C now has ‘til November 25 to come up with the bonds and E can’t do anything on the close-out until November 27, at the earliest.

A: That’s right.

105. Q: All right. So, by the close of business on November 5 I have to call C and tell him I’m retransmitting, and the new dates for delivery and execution, as extended because of my retransmittal. Do I have to tell E of the extension of time?

A: Of course. On the same day that you telephone C to notify him about the

retransmittal, you must also telephone E and notify him of the extension of time. If you remember our transaction flow chart back at question 96, you can see on the left page how these two notifications would be diagrammed.

106. Q: Do I have to confirm any of this in writing?

A: Yes. Both of these notifications must be confirmed in writing. The rule also

specifies the minimum contents for each notice.

107. Q: What has to be in the notice of retransmittal to C?

A: The rule requires the following information:

1. Your bank’s or firm’s name.

2. The name and address of the dealer who originated the close-out notice which you are retransmitting.

3. The name and address of the dealer you’re sending the retransmittal notice to (remember our discussion in question 21 about addresses). 4. The name of the person to whom you spoke when you provided the telephone notice of the retransmittal.

6. A description (including the par value amount) of the securities involved in the transaction that you’re retransmitting the close-out notice on. 7. The trade date and settlement date of the transaction.

8. The price and total dollar amount of the transaction.

9. The deadline by which the securities must be delivered to the originator in order to avert the close-out (as extended due to the retransmittal). 10. The date or dates during which the close-out can be executed (as extended due to the retransmittal).

11. Your name and telephone number, or the name and telephone number of someone else the seller can contact about the retransmittal.

108. Q: Why do I have to put the originating dealer’s name on?

A: As we’ll see below, if other dealers retransmit the notice, they will have to

advise the originating dealer of the retransmittal. In addition, the dealers to whom the notice is retransmitted will need to know who the originator is in case a late delivery is made or in case someone has information about the status of the transaction which the originator should be informed of.

109. Q: When do I have to send that written notice out?

A: Not later than the business day following the date of your telephone notification

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32 33

you would have to send the written notice by November 6. Note also that it must be sent return receipt requested.

110. Q: What about the notification to the originating dealer about the extension of dates?

A: That has to contain the following:

1. Your firm’s or bank’s name.

2. The name and address of the dealer originating the notice of close-out (and to whom you’re sending the notice of extension of dates).

3. The name of the dealer to whom you retransmitted the notice. 4. The name of the person to whom you spoke when you provided the telephone notice of the extension of dates.

6. A description (including the par value amount) of the securities involved in the transaction that you’re giving the notice on.

7. The date specified by the originating dealer as the deadline date for delivery of the securities.

8. The new deadline date for the delivery of the securities, as extended due to the retransmittal.

9. The date or dates during which the close-out can be executed, as extended due to the retransmittal.

10. Your name and telephone number, or the name and telephone number of someone else the originator can contact about the close-out.

111. Q: When must that notice be sent?

A: That notice must also be sent not later than the close of business on the

business day following the date of your telephone call, and also must be sent return receipt requested.

112. Q: Do you have suggested forms for those notices also?

A: Yes. They are reprinted on the following two pages.

Notice of Retransmittal of Close-Out

Date: ___________________________ To: ___________________________

___________________________ ___________________________ ___________________________

Attn: ___________________________

_________________________________________________________________________

which is due from you to the undersigned on a contract made on

__________________________ at ___________________________ for settlement

(trade date) (contract price)

___________________________ vs. ___________________________.

(settlement date) (total amount)

Pursuant to MSRB rule G-12(h), we hereby advise you that we are retransmitting a notice of close-out received by us from ___________________________. If the above-described

(name of originator)

securities are not delivered to them by ___________________________, they have indicated that (extended delivery date)

they intend to execute a close-out with respect to these securities during the period

___________________________ to___________________________. ___________________________

(extended date) (extended date) (name)

of your office was contacted on ___________________________ regarding this retransmittal. (date)

(21)

113. Q: Can I summarize so far? If I, as a selling dealer, receive a close-out notice from a purchaser, I must check to determine what my reason for failing to deliver the securities is. If I am failing to deliver for any reason other than that I’m failing to receive from another dealer, we’re in a two-party close-out, and we proceed as described in the earlier part of this booklet.

A: That’s generally true, except in the case of securities submitted for transfer, in

which case you follow the procedure described in questions 157-171.

114. Q: But if I have a fail to receive from another dealer I can retransmit the notice to the other dealer. I do that by calling him, not later than the business day following the day I received the notice. I advise him that I am retransmitting a notice to him, that the notice is from such-and-such a dealer, and that the deadline date for delivery is “x” and the execution dates are “y.” I confirm that in a written notice, containing certain specified contents, and sent, return receipt requested, on the following business day.

A: That’s correct. And now the time extensions.

115. Q: If this is the first retransmittal, that applies a time extension of 5 business days to the delivery deadline and execution period specified by the originating dealer—they get moved back 5 business days. Since I’m the first retransmitting party I figure out the time extension and apply it when I’m retransmitting.

A: That’s right. The “x” and “y” dates you mentioned in question 114 will be

those extended dates.

116. Q: Right. After I transmit the notice by telephone, I advise the originator, also by telephone, that I’ve retransmitted the notice and that the 5 business day time extension has been applied. I confirm that in a written notice, containing specified information, also sent return receipt requested on the following business day.

A: Correct.

Subsequent Retransmittals

117. Q: We set up our example so that there would be several retransmittals after mine. How would those subsequent retransmittals work?

A: Let’s recall where we left our example. On November 5 you had called C and

E about your retransmittal. Your retransmittal extended the delivery deadline to November 25, and the execution period to November 17-December 3, as is shown on the next page.

Notice of Extension of Dates

Date: ___________________________ To: ___________________________

___________________________ ___________________________ ___________________________

Attn: ___________________________

_________________________________________________________________________

on which, pursuant to MSRB rule G-12(h), you have issued a close-out with a delivery deadline of __________________________.

We hereby advise you that we have retransmitted such Notice of Close-Out to ___________________________.

(name of dealer)

Since such retransmittal is an initial retransmittal, the dates of your notice are thereby extended – the new delivery deadline is ___________________________, and the new execution period is

(date and time of deadline)

from ___________________________ to ___________________________.

(date) (date)

___________________________ of your office was contacted on ___________________________

(name) (date)

regarding this extension.