Over the past several years, local government issuers have increasingly been privately placing bonds and other municipal debt obligations directly with banks or other purchasers rather than utilizing an underwriter to sell the bonds publicly. The Securities and Exchange Commission (the "SEC") is concerned that investors in publicly offered debt do not have adequate or timely information about privately placed obligations.
In 2018, the SEC adopted amendments (the "Amendments") to the continuing disclosure provisions of Rule 15c2-12 (the "Rule") to address that concern. The Amendments are effective on February 27, 2019. However, it is important to keep in mind that the Amendments apply only to municipal securities for which an issuer or obligated person (collectively, an "Issuer") has entered into a written continuing disclosure agreement or contract (an "Undertaking") executed on or after February 27, 2019. Undertakings entered into prior to February 27, 2019, are not impacted.
The Amendments contain many undefined terms and raise numerous practical implementation questions. The guidance discussed below is general in nature; many questions are likely to arise as Issuers implement the Amendments. We encourage Issuers to contact bond counsel or disclosure counsel with questions regarding the implementation of the Amendments.
A Very Brief Continuing Disclosure Refresher
Since 1995, paragraph (b)(5) of the Rule has prohibited underwriters from purchasing or selling municipal securities covered by the Rule unless the underwriter has reasonably determined that an Issuer has agreed in a written Undertaking to provide specified information to the market on an ongoing basis. Very generally, the information to be provided consists of: (i) annual financial information and operating data, (ii) annual audited financial statements, if available; and (iii) timely notice of the occurrence of certain events ("Event Notices"). Each of these items, and the timing for disclosure, is specified in an Undertaking related to a specific issue of municipal bonds.
Currently, the required financial information and Event Notices are provided to the market via the Municipal Securities Rulemaking Board's ("MSRB") Electronic Municipal Market Access ("EMMA") system.
Event 15 and Event 16 Generally. Prior to the Amendments, the Rule specified 14 events for which Event Notices are required to be filed. The Amendments add two additional events to the Rule. As described below, these are referred to as "Event 15" and "Event 16" in this discussion. For Undertakings entered into on or after February 27, 2019, Issuers must also agree to post an Event Notice to EMMA within 10 business days of the occurrence of either Event 15 or Event 16.
Event 15 requires an Event Notice as described below:
(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.
Event 16 requires an Event Notice as described below:
(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.
Financial Obligation is Defined; Other Terms are Not. The Amendments also added a definition of "financial obligation" to the Rule. Essentially, a "financial obligation" is a privately placed obligation, such as a bank loan or a direct placement of securities. The Amendments define "financial obligation" to mean a:
- (A) Debt obligation;
- (B) Derivative instrument entered into in connection with, or pledged as security or a source of payment for, an existing or planned debt obligation; or
- (C) Guarantee of an obligation or instrument described in paragraph (A) or (B).
The term "financial obligation" does not include municipal securities as to which a final official statement has been provided to the MSRB consistent with the Rule. Basically, this means that publicly offered/underwritten obligations for which an official statement has been provided to the MSRB do not constitute "financial obligations" for purposes of Event 15 and Event 16.
The Rule does not define any of the terms used in the definition of "financial obligation." The SEC's adopting release with respect to the Amendments (the "Release") indicates that the term "financial obligation" includes only debt, debt-like, and debt-related obligations. Ordinary financial and operating liabilities incurred in the normal course of an Issuer's business do not constitute "financial obligations." According to guidance contained in the Release, a "debt obligation" is a vehicle to borrow money. Any short-term or long-term debt obligation of an Issuer under the terms of an indenture, loan agreement, lease, or similar contract is covered by the term debt obligation. This guidance means that operating leases (for copiers and other equipment, for instance) should not constitute "debt obligations" regardless of size or duration. Conversely, the SEC specifically provided guidance that the term "debt obligation" generally should be considered to include lease arrangements that operate as vehicles to borrow money (certificate of participation transactions, for example). Agreements that do not fall neatly into these two categories will need to be analyzed on a case-by-case basis.
Similarly, the Rule does not define "derivative instrument." However, the Release offers guidance that the definition is limited to derivative instruments entered into in connection with, or pledged as security or a source of payment for, an existing or planned debt obligation. A derivative instrument could be a swap, futures contract, forward contract, option, or any similar instrument to which an Issuer is a counterparty if the instrument is designed to hedge against the risks of a related debt obligation. Derivative instruments designed to mitigate investment risk are not included in the definition.
Finally, "materiality" is an elusive concept under the federal securities laws that is based on the facts and circumstances of a particular scenario and the Amendments do not provide a definition. Generally, something is material if there is "substantial likelihood that a reasonable security holder would consider the information important in deciding whether to buy or sell a security." Some factors about what constitutes "materiality" include the size of an Issuer's overall balance sheet, the size of existing obligations or the size of the overall bond portfolio. However, the Release specifically cautions that these are not the only factors that are relevant in evaluating the facts and circumstances surrounding financial obligations.
What must an Issuer do on or after February 27, 2019?
General. If an Issuer issues new securities that are subject to the Rule on or after February 27, 2019, the Amendments apply and Event 15 and Event 16 must be included in the related Undertaking. This means that an Issuer will be required to disclose any financial obligations or other contracts specified in Event 15 that are incurred in the future (if they are material), but the Issuer is not required to retroactively disclose any obligations or contracts previously entered into. However, the Issuer must provide notice of the occurrence of any of the items listed in Event 16 that occur in connection with any of its financial obligations, regardless of when they were issued.
The Amendments apply only if an Issuer enters into an Undertaking on or after February 27, 2019, with respect to publicly offered municipal securities that are subject to the Rule. The Amendments to not apply retroactively to Undertakings entered into prior to February 27, 2019. For example, if an Issuer entered into Undertakings with respect to bonds issued in 2013 and 2017, the Amendments do not apply to those bonds.
An Example. An Issuer entered into a bank loan in 2016. Because it was a private placement, no Undertaking was required. On April 1, 2019, the Issuer closes on $15,000,000 of publicly offered fixed rate bonds and enters into an Undertaking with respect to those bonds. The Undertaking includes Event 15 and Event 16 as required by the Amendments and the Issuer now has the contractual obligation to provide Event Notices for those events. In October 2019, the Issuer enters into another privately placed bank loan and no Undertaking is required. In June 2019, the Issuer forgets to file an insurance certificate with the bank that issued the 2016 loan as it had covenanted to do, resulting in a covenant default under the loan agreement. In December 2019, the Issuer's largest taxpayer closes and the Issuer notifies the banks holding the 2016 loan and the 2019 loan that it will not be able to meet its debt service obligations in the next several years; the Issuer and the Banks negotiate an extension of the loan terms and a reduction in annual payments.
After executing the April 2019 Undertaking, Event 15 requires the Issuer to disclose any new material financial obligations on EMMA, but the Issuer is not required to disclose prior financial obligations. Therefore, the Issuer is not required to disclose the 2016 bank loan. However, the Issuer must disclose the October 2019 bank loan if it is material.
Event 16 does not require the Issuer to disclose the covenant default, because it does not reflect financial difficulties. However, the Issuer likely must disclose the amendments to both loans since the modification of terms reflects financial difficulties.
Other Considerations. Issuers should be aware that in connection with a new issue of municipal securities subject to the Amendments, underwriters will not only review the Undertaking being executed in connection with the new securities to determine compliance with the Amendments, but may also inquire about the Issuer's existing "financial obligations" and the material terms of those financial obligations (whether or not they are required to be reported under Event 15).
In addition, underwriters will likely inquire as to whether the Issuer has policies or procedures reasonably designed to comply with the Amendments. If the Issuer does not have formal policies and procedures, it should be able to describe the steps it takes to ensure compliance with its undertakings.
With respect to the Amendments, the Government Finance Officers Association ("GFOA") has advised its members as follows:
- creating a master list of all current financial obligations including, but not limited to, bank loans, capital leases, derivatives, as well as any guarantees of these types of obligations,
- developing a system to track any financial difficulties related to these obligations,
- having a process in place to add new financial obligations, and
- working with counsel to determine materiality of your financial obligations and when financial difficulties may arise."
The GFOA guidance regarding the Amendments can be found at http://www.gfoa.org/new-amendments-sec-rule-15c2-12.
The MSRB also has resources available for Issuers regarding the Amendments. See http://www.msrb.org/~/media/Files/Resources/10-Things-to-Know-New-SEC-Rule-15c2-12.ashx and http://www.msrb.org/EducationCenter/Issuers/Disclosing.aspx.
There are a number of ambiguities regarding implementation of the Amendments. It is not certain when or if the SEC will provide additional guidance and market practices will likely vary during the early stages of implementing the Amendments. In the meantime, if you have any questions regarding the Amendments, please contact us.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.