Since 2009, issuers and obligated persons1 have increasingly used direct placements as substitutes for publicly offered municipal securities. The dollar amount of commercial bank loans to state and local governments has nearly tripled since the financial crisis, increasing from $66.5 billion as of the end of 2010 to $190.5 billion by the end of first quarter 2018.2 In comparison, the dollar amount of municipal securities outstanding remained relatively flat over the same time period. Historically, disclosure of direct placements by obligated persons has been voluntary. Effective February 27, 2019 (the “Compliance Date”), this will no longer be the case in most instances.
The Securities and Exchange Commission (the “SEC”) indirectly regulates disclosure by obligated persons pursuant to Rule 15c2-12 (the “Rule”) under the Securities Exchange Act of 1934, as amended. The overarching purpose of the Rule is to address fraud in the municipal securities market by enhancing disclosure. To this end, the Rule requires brokers, dealers, and municipal securities dealers that are acting as underwriters in primary offerings of municipal securities (“Underwriters”) to reasonably determine that obligated persons have agreed to provide to the Municipal Securities Rulemaking Board (MSRB) timely notice of certain material events. Underwriters comply with this requirement by, in-turn, requiring that an obligated person undertake in a written agreement or contract (an “Undertaking”) to provide certain financial information, operating data and event notices to the MSRB—through its Electronic Municipal Market Access (EMMA) website—in a manner that is consistent with the requirements of the Rule.3 Disclosures under the Rule must occur within ten business days after the occurrence of the material event.4
On August 20, 20185, the SEC issued Release No. 34-83885 adopting amendments (the “Amendments”) to the Rule. The Amendments add the following two new events to the list of reportable events set out in paragraph (b)(5)(i)(C) of the Rule for which an obligated person must provide notice to the MSRB’s EMMA website:
(15) Incurrence of a financial obligation of the obligated person, if material, or agreement to covenants, events of default, remedies, priority rights, or other similar terms of a financial obligation of the obligated person, any of which affect security holders, if material; and
(16) Default, event of acceleration, termination event, modification of terms, or other similar events under the terms of a financial obligation of the obligated person, any of which reflect financial difficulties.
The Amendments also add a definition of “financial obligation” to the Rule—meaning a (i) debt obligation; (ii) derivative instrument entered into in connection with, or pledged as security or a source of payment for, an existing or planned debt obligation; or (iii) guarantee of (i) or (ii). Notably, this definition does not include ordinary financial and operating liabilities incurred in the normal course of an obligated person’s business, only an obligated person’s debt, debt-like, and debt-related obligations. The term “debt obligation,” which is included in the definition of “financial obligation,” includes leases “that operate as vehicles to borrow money” as well as other short-term and long-term debt obligations of an obligated person under the terms of an indenture, loan agreement, lease or similar contract. The material terms of a financial obligation that should be disclosed include the date incurred; the principal amount; maturity dates and amortization; interest rate, if fixed, or method of computation, if variable, and default rates; and such other terms as are appropriate under the circumstances. Assuming materiality, an obligated person will need to make a further determination as to whether to disclose said material terms in summary form or by posting the entire contract or agreement to EMMA. In this regard, the SEC has stated that an agreement that is posted to EMMA may be redacted to exclude confidential information such as contact information, account numbers and other personally-identifiable information, but did not indicate that commercially-sensitive information (such as the interest rate or interest rate spread under a direct placement) could be redacted if that information is material to investors.6
Defaults under new paragraph (b)(5)(i)(C)(16) of the Rule may be monetary defaults, where an issuer or obligated person fails to pay principal, interest, or other funds due, or a non-payment related default caused by the failure of a obligated person to comply with specified covenants. There is no separate materiality standard under this reportable event—rather, the test is whether the event reflects financial difficulties of the obligated person. Critically, the SEC has determined that there are defaults that may reflect financial difficulties of an obligated person—and therefore must be disclosed—even if they do not qualify as “events of default” under transaction documents. Events that may have potential adverse impacts on an obligated person’s liquidity and overall creditworthiness, or may affect security holders, will need to be disclosed.7 This determination will require the exercise of judgment on the part of an obligated person and will likely result in reporting if there is any uncertainty as to whether the standard is met.
The Amendments do not affect existing Undertakings or Undertakings made prior to the Compliance Date. Nor is there is any obligation on the part of obligated persons to amend their existing Undertakings to include the Amendments. Obligated persons with Undertakings entered into on or after the Compliance Date must disclose, pursuant to new paragraph (b)(5)(i)(C)(15) of the Rule, material financial obligations incurred on or after the Compliance Date. However, an event under the terms of a financial obligation pursuant to new paragraph (b)(5)(i)(C)(16) that occurs on or after the Compliance Date must be disclosed regardless of whether such obligation was incurred before or after the Compliance Date. For example, if an obligated person extends the maturity of 2013 bank loan because it lacks sufficient funds to repay the loan at maturity, such event would likely need to be disclosed under a post-Compliance Date Undertaking.
Impact on Private Lenders
Under the current regulatory framework, investors and other market participants may not have any access or timely access to information related to the incurrence of financial obligations and other events included in the Amendments, despite their potential impact on the risks of, and returns to, municipal securities. Moreover, to the extent information about a financial obligation is disclosed and accessible to investors and other market participants, such information currently may not include certain details about a financial obligation. As a result, investors could be making investment decisions on whether to buy, sell or hold municipal securities without current information about an issuer’s or obligated person’s outstanding debt and other market participants could also be undertaking credit analyses without such information. The Amendments seek to address this information divergence.
The SEC has determined that lenders may incur costs under the Amendments stemming from the disclosure of financial obligations and the terms of the agreements creating such obligations. As discussed above, lenders may currently enjoy certain priority rights in these financial arrangements which may not be publicly disclosed or reflected in the price of the issuer’s or obligated person’s outstanding municipal securities. While the increased level of disclosure under the Amendments may reduce lenders’ information advantage over other investors, it does not eliminate this advantage entirely because private lenders such as banks actively engage in information gathering and monitoring of borrowers and thus develop proprietary information during the lending relationship. Disclosure is also unlikely to alter the lender’s senior status in the debt priority queue. As reasoned by the SEC, to the extent that the benefits from a previously undisclosed financial arrangement are reduced by the increased disclosure, lenders will incur a cost, but such a cost translates into benefits to investors, because the benefit originally accrued to lenders at the expense of investors in municipal securities.
In addition, since the Amendments may decrease the costs incurred by obligated persons in connection with the issuance of public debt and increase the demand for public issuance, lenders may experience reduced investment opportunities, or may have to decrease loan rates in order to stay competitive, either of which could generate a cost to them. However, the SEC does not believe the Amendments will significantly alter the composition of the existing municipal debt market. While some obligated persons, seeing the cost of public debt decrease, may have incentives to increase public issuance, obligated persons that are heavily reliant on direct placements may see the increase in disclosure as more costly than the benefit from the reduced cost of public debt, and therefore choose to use private debt exclusively.
- As used herein and as defined in the Rule, the term “obligated person” means any person, including an issuer of municipal securities, who is either generally or through an enterprise fund, or account of such person committed by contract or other arrangements to support payment of all, or part of the obligations of the municipal securities to be sold in the offering (other than providers of municipal bond insurance, letters of credit, or other liquidity facilities). 17 C.F.R. § 240.15c2-12(f)(10).
- Amendments to Municipal Securities Disclosure, 83 FR 44730, note 319 (citing Federal Deposit Insurance Corporation, Consolidated Reports of Condition and Income, available at https://www.fdic.gov/regulations/resources/call/index.html).
- In addition, in connection with the issuance of the municipal securities, Underwriters must reasonably determine that the issuer or obligated person has complied with its prior continuing disclosure undertakings, or accurately disclosed in its Official Statement relating to such securities any failures to comply with such undertakings, within the past five years.
- The reporting of an event is only required if material. Materiality under the Rule is evaluated using general securities law concepts—i.e., a piece of information must be disclosed by an obligated person if there is a substantial likelihood that, under all the circumstances, “the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information available.”
- The Amendments were published in the Federal Register on August 31, 2018 at 83 FR 44700.
- The combination of uncertainty over the materiality standard and the ten business day notification requirement may result in the vast majority of bank loans, direct placements and swap transactions being reported and with all documentation on these transactions being reported instead of the portion of such documentation that may apply under new paragraph (b)(5)(i)(C)(16) of the Rule.
- Modifications and waivers of terms of a financial obligation provided by lenders to obligated persons give rise to uncertainty under the Amendments. For example, if an obligated person is unable to meet a certain financial covenant and the lender agrees to waive the covenant because other financial ratios and covenants meet their lending guidelines, the obligated person will need to make a determination as to whether this type of waiver should be disclosed. Under these circumstances or similar situations, it is possible that a lender may hesitate to accommodate an obligated person if the obligated person is required or advised to disclose the full details of the waiver or accommodation.