Public Finance Alert
In mid-August, the SEC adopted amendments to its Rule 15c2-12 (the “Rule”), following 18 months of review of comments made to its original proposed amendments. The SEC action will be published in the Federal Register shortly. The compliance date of the new amended Rule (“2018 Amendments”) is 180 days after publication. 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.
New “Material Events.” The 2018 Amendments add two new “events” for which Issuers would be contractually obligated through new CDAs signed after the compliance date to report on EMMA within 10 days of occurrence (the numbering used here reflects the addition of these events to a list contained in the text of the Rule):
(15) Incurrence of a “financial obligation” of the [Issuer], if material, or agreement to covenants, events of default, remedies, priority rights or other similar terms of a financial obligation, any of which affect security holders, if material.
This item would apply to financial obligations entered into, or covenants etc. made, only after the issuance date of a new bond issue to which a new CDA is signed.
(16) Default, event of acceleration, termination event, modification of terms or other similar events under a financial obligation of an Issuer, if any such event reflects financial difficulties.
This item would require reporting any such event which occurs after a new CDA is signed, but with respect to all financial obligations of the Issuer, whether entered into before or after the relevant CDA.
The two new material events adopted in the 2018 Amendments are identical to the language proposed in 2017.
Critical to the 2018 Amendments is a new definition of “financial obligation,” which is needed in order to implement the new events (15) and (16):
Financial Obligation means 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).
As defined, a financial obligation excludes any municipal security for which an official statement is posted to EMMA pursuant to the Rule.
Reduced Scope of “Financial Obligation.” It was understood when these amendments were proposed in 2017 that the SEC was responding to concerns that the growth of private placement and direct bank loan transactions, which are not subject to any reporting obligations of the Rule, had created an information gap. However, the original proposal contained a very broad definition of “financial obligation” which went far beyond private placements of debt, and included leases, derivative instruments, guarantees and monetary obligations under judicial, administrative or arbitration proceedings. This resulted in widespread opposition from many corners of the municipal market, and the SEC has in the 2018 Amendments pulled back the scope of the definition to just cover debt and certain debt-related obligations. The SEC made clear in its Release announcing the 2018 Amendments that it intends to cover any obligation that acts like a debt, meaning a borrowing of money intended to be repaid over time, regardless of its duration (short or long) or its name. For purposes of complying with the 2018 Amendments, debt is not defined by state law. Furthermore, although the term “lease” was taken out of the definition, the SEC expects that lease-purchase or certificate of participation transactions in the form of a lease (what used to be called a “capital lease”) are covered.
Materiality. A large number of comments on the proposed amendments criticized the use of the term “material” and “reflecting financial difficulties” as standards for when a material event report must be made. The SEC rejected all of these comments and declined to provide any further guidance on how to test for materiality, so issuers and obligors will continue to have to review their own facts and circumstances to decide when a report has to be made. Given the lack of clarity on this term from the MCDC process a few years ago, this will create significant difficulties for implementation by issuers and underwriters, who have an obligation in a new bond transaction to verify if the issuer has complied with its prior CDA undertakings.
Next Steps. Although there will be six months before new bond issues must include the 2018 Amendments in a CDA, issuers would be well advised to start analyzing how the new reporting requirements will impact them, to update disclosure practices and policies and establish internal monitoring mechanisms to detect covered events. Issuers will want to consult in advance with their disclosure or bond counsel to think about how to measure materiality for this new Rule. The urgency of this task will vary widely. Infrequent Issuers may not face these considerations for years. Underwriters will need to update their diligence procedures prior to the compliance date.
There are many open questions about how to interpret and implement the 2018 Amendments. For instance, can an Issuer specify in advance in its CDA what threshold it plans to use (absent other factors) for determining if a new debt obligation is material to existing bondholders (e.g. some percentage of its general fund revenues)? New information may come from the SEC itself (as occurred when the Rule was originally adopted), or from conferences among lawyers or municipal organizations. Orrick lawyers will continue to keep our clients informed about any such developments and will work with our clients to assist in interpreting and preparing for implementation of the new rules.
If you have further questions at this time, please feel free to reach out to a member of Orrick’s Public Finance Department.