Public Finance Alert | April.27.2017
Recently, the SEC proposed amendments to Rule 15c2-12 (the "Rule"), which was published in the Federal Register on or about March 16. Since 1995 governmental issuers and other obligors (like nonprofit health care institutions using tax-exempt debt) (collectively, "Issuers") have, as a condition of being able to use an underwriter to market their bonds, had to sign "continuing disclosure agreements" ("CDAs") promising to supply annual financial reports and to provide prompt notice upon the occurrence of certain events which would materially affect the bond issue subject to the CDA.
The proposed amendments to the Rule (the "2017 Proposed Amendments") are ostensibly in response to widespread commentary within the municipal securities community calling for better dissemination of information about bank loans or other non-publicly offered private placements. However, if implemented without change, the 2017 Proposed Amendments would greatly complicate and increase the expense of financial monitoring and reporting for any size government using the public debt markets, and could profoundly change the nature of federal regulation of the municipal market. While many organizations are expected to submit comments to this proposal, robust input from individual Issuers will be highly valuable. Comments are due by May 15, 2017 but any comments submitted reasonably quickly should be read by the SEC staff.
Proposed New "Material Events." In brief, the proposal would add two new "events" for which Issuers would be contractually obligated to report on EMMA within 10 days of occurrence:
(i) Incurrence of a "financial obligation," if material, or agreement to certain covenants or terms in a financial obligation, if material. This item would apply to financial obligations entered into, or covenants etc. made, only after the effective date of a new bond issue to which a new Continuing Disclosure Certificate is signed.
(ii) Default, event of acceleration, termination event, modification of terms or other similar events under a financial obligation, if any such event reflects financial difficulties. This item would require reporting any such event which occurs after a new CDC is signed, but with respect to all financial obligations of the issuer, whether entered into before or after the relevant CDC.
Critical to the new rule is the broad definition of "financial obligation," of which arguably only clause (a) relates to bank loans or private placements:
"Financial Obligation means a (a) debt obligation, (b) lease, (c) guarantee, (d) derivative instrument or (e) monetary obligation resulting from a judicial, administrative or arbitration proceeding." Excluded is any municipal security for which an official statement is posted to EMMA (i.e. any public bond issue otherwise subject to Rule 15c2-12).
Far Reaching Implications. As proposed, new "financial obligations" would have to be reported when entered into by an Issuer or when a monetary judgment is reached, and both new and old "financial obligations" have to be monitored for defaults, modification of terms or other events. The burden of tracking every lease, court judgment or other debt or possibly debt-like obligation entered into by an Issuer's entire organization – all departments, bureaus, divisions, agencies, etc. – would be an enormous undertaking, and an unfunded obligation. Moreover, the expansion of reporting obligations under Rule 15c2-12 from those affecting just the bonds subject to the CDA, to any one of a list of financial metrics affecting the Issuer's credit, is a fundamental change in the way the SEC (indirectly) regulates municipal governments, and moves municipal governments into the realm of "ongoing financial disclosure" which corporations have to follow, particularly by analogy of Form 8-K under the Securities Exchange Act of 1934. While corporations (including those which use the municipal debt market) may be organized enough to be able to monitor all these new events, governments frequently are not – either by lack of sophisticated central controls or by the sheer size and complexity of a large government. The SEC is using concerns about the growth of bank loans or private placements to bootstrap a sea change in disclosure practices in the municipal market.
Materiality – The Great Unknown. Aside from overreach described in the last paragraph, another serious flaw in this proposal is that the standard set forth for compliance is far too nebulous. The SEC release suggests that using a standard of "materiality" strikes a balance between having to report very small obligations (copier leases) and those which could affect other bondholders. Likewise, the SEC indicates that the standard of "which reflects financial difficulties" provides a good test for the new "event" to be reported under clause (ii), above.
However, the SEC has not defined what is "material" (and "financial difficulties" is really another aspect of materiality). In the wake of the MCDC process, Issuers and underwriters will be very reluctant to make a judgment on what is or is not a material action requiring reports. The absence of a definition of materiality from the SEC places an incalculable responsibility on Issuers and the financial staff that shoulder the burden of monitoring "financial obligations" and continuing disclosure compliance matters to make a determination as to materiality for reporting and compliance. Further, since the new rule requires reporting of material covenants and agreements, Issuers will avoid the task of trying to summarize what are the material terms by posting to EMMA entire documents (with confidential matters blacked out), creating an impossible burden for investors and analysts hoping to actually understand the significance of any new bank loan, derivative or lease, for instance.
Limitation on Financial Market Access. It has been argued that small or infrequent Issuers can avoid this burden by simply avoiding the public debt market, but this would deprive them of what could be a more cost-effective borrowing option, and there is no assurance that the bank loan market will remain as robust as it is presently. Large and regular Issuers have no choice but to use the public debt market and they must suffer the burdens which this new rule would impose.
Call to Action – Comments Needed. Comments on the 2017 Proposed Amendments are due to the SEC by May 15, 2017. Every comment letter counts. It is critical that the SEC receive as many comments as possible from Issuers that will have to comply with the new regulations under outstanding and future continuing disclosure undertakings. The release of the 2017 Proposed Amendments includes questions upon which parties are encouraged to provide comments.
If you have questions about preparing comment letters for submission to the SEC, members of the Orrick team are available to assist you with preparing comment letters for submission to the SEC.