The Securities and Exchange Commission (SEC) released a National Examination Risk Alert on March 19, 2012 (the "Alert") that highlighted a number of failures in the due diligence and disclosure process for municipal securities offerings. The Alert highlights the SEC's increasing emphasis on due diligence and disclosure in the municipal securities markets and states the SEC's belief in the importance of a documented due diligence process for municipal securities as well as the need for continuing disclosure under Securities Exchange Act Rule 15c2-12 (Rule 15c2-12). The Alert recognizes that many underwriters have not established adequate procedures to ensure due diligence and disclosure compliance in accordance with Rule 15c2-12, MSRB Rule G-27 and other federal securities laws. The Alert urges underwriters as well as issuers of municipal securities to implement these types of procedures and comply with the requirements of the securities laws.
Underwriters' Due Diligence Obligations and Compliance
When an underwriter participates in an offering or sale of municipal securities, it is making an implied recommendation about the quality of the security involved in the transaction. The SEC believes that one component of the recommendation is that the underwriter has a reasonable belief in the truthfulness and completeness of the key representations made in the disclosure documents associated with the security. Failure on the part of an underwriter to demonstrate that it has formed a reasonable belief could be grounds for a violation of the antifraud provisions of the federal securities laws. Further, Rule 15c2-12 requires that underwriters review the "deemed final official statement" for accuracy and completeness and that the underwriter has reasonably determined that an issuer will comply with its continuing disclosure obligations under Rule 15c2-12. Finally, MSRB Rule G-27 requires that an underwriter have supervisory procedures in place to ensure compliance with the securities laws (including the antifraud provisions, Rule 15c2-12 and MSRB Rule G-27). While the securities laws have no explicit requirement that an underwriter maintain written evidence, the SEC has stated that maintaining proper records of due diligence activities can be the basis of an affirmative defense when the SEC charges the firm with failing to comply with its obligations.
In the Alert, the SEC rejects many current industry-held beliefs concerning due diligence and disclosure compliance. The Alert states that due diligence obligations should not be outsourced to underwriter's counsel unless counsel provides a written summary of diligence efforts and the reviewed items. Additionally, underwriters are urged to retain due diligence records after the closing of an issuance rather than discarding the materials or not collecting them at all. The SEC provides the following examples of practices that demonstrate compliance: written due diligence policies and practices, commitment committees, due diligence checklists, due diligence memoranda, due diligence calls (with accompanying agenda or minutes), on-site diligence examination and recordkeeping checklists. The Alert indicates that firms should implement a supervisory system for overseeing the due diligence and compliance efforts as well as a system for reporting disclosure issues. The Alert further stressed that an underwriter's due diligence obligations do not end with the collection and retention of the due diligence materials. The underwriter must review the diligence items provided to it by the issuer, the offering statement and other offering materials for completeness and accuracy.
Issuer's Role in Securities Compliance
In a typical municipal securities offering, issuers are required by underwriters to provide sufficient information to comply with the applicable securities laws, and issuers should expect that such information will be required of them. Issuers can comply with such requirements by maintaining current financial and other material information usually disclosed in municipal securities offerings, and by making key personnel available for diligence calls, site visits and other reviews performed by underwriters. In addition, because Rule 15c2-12 requires scrutiny of the issuer's past compliance with continuing disclosure requirements, issuers should implement compliance procedures as well as maintain a continuing disclosure compliance record after the closing of an issue. Issuer disclosures contained in the offering statement are also subject to the antifraud provisions of the securities laws, which require that an issuer disclose all material information and not make a material misstatement or omission of fact in the offering documents. Public officials, just like corporate executives, sign offering documents that are made public, and public officials can be subject to SEC enforcement actions. To ensure compliance with the antifraud provisions, issuers should implement internal procedures for due diligence and offering document review.
Once an issuer has entered the market, it must comply with its continuing disclosure requirements and should implement procedures to do so, just as issuers have implemented tax compliance procedures. Failure on the part of an issuer to comply with its continuing disclosure requirements within the previous five years must be disclosed in the final offering document and, depending on when the prior failure is discovered, an amendment indicating the compliance failure may be required. Such a disclosure in the offering document may not only affect debt pricing and timing, but also can be embarrassing. Repeated failure to comply may preclude the underwriter from underwriting the issue. Under MSRB Rule G-17, a municipal security cannot be offered for sale on the secondary market without disclosing, among other things, an issuer's past continuing disclosure compliance record, which may affect the price of the security on the secondary market and could in turn impact the pricing of future offerings. Accordingly, issuers without proper compliance systems in place run the risk of including incorrect or omitting material information or being required to include negative disclosure (or have negative disclosure made about them), which may ultimately result in a reduction in the overall value of that issuer's securities.
The financial crisis and increasing public concerns regarding the municipal securities market have prompted the SEC to focus on due diligence and disclosure aspects of municipal securities. With this increased focus, underwriters and issuers should audit their current procedures and expect that changes will be required of them to ensure future compliance. Underwriters and issuers with written policies and procedures in place that foster due diligence compliance, as well as compliance with continuing disclosure obligations, will remain attractive in an increasingly competitive market and provide for a smoother and successful financing process. We will continue to monitor changes to these requirements.
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