Recent SEC Rule Changes and Implications for Municipal Bond Issuers and Borrowers

SEC Rule 15c2-12: Background
On July 15, 2009, the SEC approved proposed amendments to its Rule 15c2-12 (Rule). The SEC has proposed that these amendments, in their final form following public comment, will become effective the third month following the approval of the final changes to the Rule. These proposed amendments are the first significant overhaul of the Rule since the base version, which was adopted in 1989, was amended in 1994 to include secondary market disclosure requirements. These amendments will have significant implications for municipal issuers and borrowers of the proceeds of municipal bonds. The effects of these amendments are outlined in this alert.

Rule 15c2-12 provides the basic framework for secondary market disclosure by issuers and borrowers in the municipal bond market. The SEC lacks statutory jurisdiction over municipal issuers, other than limited, but significant, jurisdiction and oversight that derives from anti-fraud laws, including SEC Rule 10b-5. As a consequence, the SEC’s approach to regulating secondary market disclosure by municipal issuers and the borrowers of the proceeds of municipal bonds is to impose mandates on broker-dealers, in their various roles as underwriters, placement agents, and remarketing agents, to conduct their business and discharge their general securities law obligations in a manner consistent with Rule 15c2-12.

The Rule has two basic requirements. First, it obligates underwriters to obtain and review offering documents for municipal securities (if available) and file them with the Municipal Securities Rulemaking Board (MSRB).¹ Second, it obligates underwriters and remarketing agents to ensure that issuers and borrowers have in place contractual obligations for the benefit of bondholders to prepare and file annual reports and financial information, and notices of the occurrence of certain described events (referred to as “listed events”) with the MSRB, through its Electronic Municipal Market Access (EMMA) system. A few categories of issuers and types of securities are currently exempted from the application of the Rule.

The timing of the proposed amendments is notable. The announcement of the amendments occurred at substantially the same time that the SEC and MSRB have pending other regulatory actions that also would serve to increase the quality and quantity of disclosure, and as legislators and regulatory agency leaders are increasingly criticizing the lack of jurisdiction over disclosure by municipal issuers. The announcement of the amendments also follows on the heels of the MSRB’s recent implementation of its EMMA system. Public comments by organizations as diverse as the National Federation of Municipal Analysts, the Investment Company Institute, and the Government Finance Officers Association have increasingly questioned the existing quality of disclosure. At the same time, the public policies surrounding exemption versus registration also continue to fuel the debate. Moreover, SEC Commissioner Mary Schapiro has delivered testimony and offered public statements that recommend legislative action toward removing or modifying the exemption in order to improve transparency in the municipal securities market.

In addition, the SEC recently announced changes in its enforcement division, which include the creation of a national enforcement unit specializing in municipal securities and public pensions. All of these developments must be considered in the context of the recent global financial crisis and recession, both of which have predictably resulted in the current political environment. This environment has led to intensified discussion surrounding the transparency and adequacy of disclosure in the municipal marketplace, which may lead to more substantial regulatory and statutory protection for investors and consumers beyond the proposed changes to the Rule described in this alert.

Thus, while the amendments to Rule 15c2-12, if adopted, will clarify and increase disclosure obligations, the likely investor demand for more frequent and improved quantity and quality of disclosure, together with the increasing level of public debate on the subject, will impose more pressure upon issuers and borrowers to enhance their current secondary market disclosure practices.

Proposed Amendments to Rule 15c2-12
The proposed amendments affect the obligation to disclose the occurrence of the “listed events,” and remove an exemption from continuing disclosure that currently exists for variable rate demand obligations.

• Timing of Listed Event Notices. Currently, notice of the occurrence of a listed event must be filed “in a timely manner.” The proposed amendments would require that the notice be filed within 10 business days of the occurrence of the event.
• Existing Listed Events: Materiality No Longer Relevant. The Rule currently requires that notice be given of the occurrence of any of 11 listed events, provided that notice be made only if the event is “material.” The proposed Rule removes the materiality determination for the following events:
  
  
  • Failure to pay principal and interest
  • Unscheduled payments from a debt service reserve fund that reflects financial difficulties
  • Unscheduled payments by parties providing support for the bonds, reflecting financial difficulties
  • Change in the identity of parties providing credit or liquidity support for the bonds
  • Failure of a credit or liquidity provider to perform
  • Defeasance
  • Rating changes
• Modification of Existing Listed Event: Tax Matters. Currently, notice of an adverse tax opinion or occurrence of an event affecting the tax-exempt status of the security must be given in a timely matter. The proposed amendment would expand and perhaps clarify the sort of event that would trigger a notice to include “adverse tax opinions, the issuance by the Internal Revenue Service of proposed or final determinations of taxability, Notices of Proposed Issue (IRS Form 5701-TEB) or other material notices or determinations with respect to the tax-exempt status of the securities, or other events affecting the tax-exempt status of the security.” The materiality determination apparently would apply only to notices or determinations other than those described above, including IRS audits, although in its proposed rulemaking, the SEC has asked for comment as to whether IRS audits should be a listed event, regardless of materiality.
• Existing Listed Events: Materiality Determination Permitted. The current requirement for notice of the occurrence of the following events, if material, will remain:
  
  
  • Nonpayment-related defaults
  • Modifications to the rights of security holders
  • Redemptions
  • Release, substitution, or sale of property security repayment of the securities
• New Listed Events: Materiality Not Relevant. The Rule adds four events, disclosure of two of which would be required regardless of materiality:
  
  
  • Tender offers
  • Bankruptcy, insolvency, receivership, or a similar proceeding by an obligated person
• New Listed Events: Materiality Determination Permitted. Two new events will require a notice be filed, if the event is considered material:
  
  
  • Consummation of a merger, consolidation, acquisition, or sale of all or substantially all the assets of the obligated person, or the entry into a definitive agreement to engage in such a transaction, or a termination of such an agreement, other than in accordance with its terms
  • Appointment of a successor or additional trustee, or the change in the name of the trustee
• No Exemption for Variable Rate Demand Bonds (VRDBs). Currently, bonds with authorized denominations of $100,000 or more that may be tendered at the option of the holder at least as frequently as every nine months are exempted from Rule 15c2-12. The amendments to the Rule will eliminate the exemption from the continued disclosure requirements of the Rule.

Considerations
Any significant change to federal securities laws have both intended and unintended practical consequences, including:

• The proposed revisions would apply to bonds issued after the effective date of the amendments. However, under the proposed amendments, conversions of existing bonds that are currently exempt from the Rule (such as VRDBs) will cause those existing bonds to become subject to the continuing disclosure requirements of the amended Rule if the conversion constitutes a “primary offering” as currently defined in the Rule. This would require a borrower to enter into a new continuing disclosure agreement or amend an existing continuing disclosure agreement.
• As the amendment is currently drafted, the 10-business day timeframe to provide notice starts on the day the listed event occurred, not the day on which the issuer or borrower received notice or became aware of the occurrence of the event. Borrowers and issuers do not necessarily control the flow of information needed to support the obligation to provide notice of all listed events within the proposed 10-business day timeframe. Examples include the failure of a liquidity facility provider to perform if the borrower has assigned to the tender agent or the trustee the right to draw on that facility directly to fund puts, the change in the identity or name of the trustee, or rating changes, particularly if those rating changes are predicated on a downgrade of the ratings of the credit or liquidity facility provider rather than on the issuer’s or borrower’s own rating. Borrowers and issuers will need to consider adding notice covenants to their bond documents to provide for proper and timely flow of relevant information to the borrower or the issuer and must work carefully with their investment bankers or financial advisors to stay informed about rating changes.
• In certain industries such as nonprofit health care, expansion, contraction, mergers, consolidations, acquisitions, and property sales are expected to continue. For the health care industry, these trends can be expected to intensify as health care reform takes hold. Borrowers and issuers will be required to provide continuing disclosure notice of a definitive agreement to engage in these transactions, if material, necessitating a thoughtful and comprehensive understanding of the concepts of materiality.
• Serious debate has already commenced about the propriety and necessity of expanding the tax-event notice provisions. To some extent, the removal of the materiality determination pertaining to adverse tax events eliminates the difficult decision borrowers and issuers addressed when attempting to understand the scope and potential effects of audits and IRS notice and whether to inform investors of their occurrence. However, certain tax professionals have publicly questioned whether the expansion of triggering events will be helpful and informative to investors.

Proposed Revisions to MSRB Rules and Forms
The MSRB has recently proposed revisions to its Rule G-32 and Form G-32, the effect of which will be to impose an additional series of reporting burdens upon broker-dealers regarding the continuing disclosure obligations of its clients. If adopted, these revisions will obligate the broker-dealer, in its role as underwriter, placement agent, or remarketing agent, to inform the MSRB, through its EMMA system, whether the issuer or other obligated persons have undertaken to provide continuing disclosure, the identity of those obligated persons, and the specific dates by which continuing disclosure information is to be provided.

This information will be available to investors through EMMA. The information is intended to inform investors whether continuing disclosure will be made, by whom, and by when. Although the MSRB rules do not apply to issuers and borrowers, the effect of these proposed changes will be to impose on the broker-dealer an additional obligation to monitor carefully the details of the disclosure promise and to assist investors in identifying those parties obligated to provide secondary market information. The effect of the revisions is not substantive, but when considered in the context of the proposed revisions to Rule 15c2-12, can be expected to increase the significance of the continuing disclosure obligation and its increased importance before, during, and after a bond issue.

Proposed Changes to Rules Affecting Money Market Funds
The SEC has recently proposed substantial changes to its Rule 2a-7, which affects taxable and tax-exempt money market funds. Although most of the changes are highly technical and many address internal monitoring processes of these funds, some of the changes can be expected to increase pressure on issuers and borrowers from money market funds to provide, on a timely basis, the information they need in order to satisfy their obligations under Rule 2a-7, including those currently in place and those proposed. A thorough examination of the proposed revisions to Rule 2a-7 is beyond the scope of this alert.

¹ Until July 1, 2009, those documents, and others described in this alert, were filed with Nationally Recognized Municipal Securities Information Repository (NRMSIRs). On that date, the repository maintained by the MSRB, known as EMMA, was the only recognized repository.

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